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Long-term themes review March 7th 2018

FullerTreacyMoney has a very varied group of people as subscribers. Some of you like to receive our views in written form, while others prefer the first-person experience of listening to the audio or watching daily videos.

The Big Picture Long-Term video, posted every Friday, is aimed squarely at anyone who does not have the time to read the daily commentary but wishes to gain some perspective on what we think the long-term outlook holds. However, I think it is also important to have a clear written record for where we lie in terms of the long-term themes we have identified, particularly as short-term market machinations influence perceptions.

Pimco Sells Australia Banks, Property Bonds as Risks Climb

This article by Ruth Carson and Andreea Papuc for Bloomberg market be of interest to subscribers. Here is a section:

Risk assets are vulnerable to a correction as valuations approach fair value, Thakur and John Dwyer, vice president and credit research analyst, wrote in a report.

“This risk becomes more important as we transition to a period of gradual tightening of monetary policy by global central banks,” according to the report. Asset prices offer little buffer to the risk of possible shocks resulting from negative growth surprises or higher-than-expected inflation, they said.

Australian government yields share a high degree of commonality with those of other developed market nations. The 10-year has been ranging below 3% since 2015 and over the course of the last month has pulled back to test the region of the trend mean. With inflationary pressures being more of a fear than a reality at present there is scope for some further steadying in the market.

Gundlach Disagrees with Mnuchin and Powell

Thanks to a subscriber for this article by Robert Huebsche for Advisor Perspectives summarizing Jeff Gundlach’s talk for DoubleLine clients yesterday. Here is a section:

He said that deficits have historically shrunk in non-recessionary periods and risen during recessions. “We are late in the economic cycle,” he said, “and it is unusual that the deficit is expanding.” He said that this is driven by political reasons, and noted that the fact that we are adding stimulus “has never happened before.”

Deficit problems will move to the forefront by the end of this year, he said. The deficit is getting a lot worse and there will be “a lot of bonds supplied to the market,” he said. The supply of bonds was about $650 to $700 billion in 2017, he said. It will be $1.2 to $1.3 trillion in 2018, in addition to quantitative tightening (QT) as the Fed contracts its balance sheet, according to Gundlach. There could be another $600 billion in tightening, he added.

If there is a recession the deficit will get worse, he said, but QT will stop. Either way, investors should expect $2 trillion in supply.

”If quantitative easing (QE) was a tailwind for financial assets, then QT must necessarily be a headwind,” he said.

The unique conditions that prevailed in 2017 are over, Gundlach said. The VIX is above 17, he said, which is higher than at any time in 2017. “We have lived the entire last month and a half at VIX levels higher than in 2017,” Gundlach said. As a result, the markets turned in the greatest Sharpe ratio ever in 2017, but he said that has flipped in 2018.

“We’ve gone from an easy to a very tough investing environment,” Gundlach said.

Gundlach predicted that the S&P 500 will have a negative rate-of-return this year. “My conviction is high,” he said, “higher than that the 10-year yield will break to the upside.

A link to the full deck of Gundlach’s slides is posted in the Subscriber's Area.
The S&P500 is currently up 2.88% this year but it hit at least a near-term and potentially medium-term peak in January following a brief acceleration of the two-year uptrend.

Bigger U.S. Auctions in Shorter Time Seen Boosting Yields

This note by Brian Chappatta for Bloomberg may be of interest to subscribers. Here is a section:

Bond traders have to contend with both larger auction sizes and a condensed schedule when the U.S. Treasury sells $28 billion of three-year notes and $21 billion of 10-year notes on March 12. To JPMorgan Chase & Co. strategists, that combination signals a weak reception. Last month’s offerings, the first since 2009 to increase in size, priced at yields higher than the market was indicating heading into the sales. The 3- and 10-year auctions are usually spaced out over two days, but when they came on the same day in December, yields also missed higher.

Bull markets don’t often end because demand evaporates. They usually end because the surge in prices encourages supply into the market and that eventually overwhelms demand. There is no shortage of new supply, in fact the USA’s decision to double its deficit is the latest in a long line of issuers who have been locking in low rates. The fact that one of the biggest buyers, the Fed, is now a net seller, should be giving investors pause when thinking about the value represented by bonds at close to 3%.

Draghi Says Euro-Area Turnaround Warrants Policy Dial-Back

This article by Piotr Skolimowski for Bloomberg may be of interest to subscribers. Here is a section:

The European Central Bank unexpectedly dropped a pledge to ramp up bond buying if the economy deteriorates, saying the turnaround in the outlook has given it to confidence to change a key part of its monetary-policy guidance.

In what the ECB President Mario Draghi said was a unanimous decision, policy makers in Frankfurt surprised investors by ending an easing bias on quantitative easing, effectively a conditional promise to increase debt purchases in “size and/or duration” if needed. But he said downside risks remain, and added rising trade protectionism to the list of threats.

“These are unlikely contingencies now, the ones that would suggest that we would activate this easing bias,” Draghi said Thursday. The language “was introduced in 2016 -- think about how different the situation was at that time.”

The revision coincided with an upgrade to the ECB’s outlook for 2018. At the same time, Draghi emphasized that, currently scheduled to run at a monthly pace of 30 billion euros ($37

billion) until at least the end of September, will continue until inflation is solidly back on track toward its goal.

The ECB is edging towards the exit of quantitative easing. First, they put an end date on purchases, now they are removing the proviso that purchases will be increased and in September they will cease to add €30 billion to their balance sheet. This timetable is subject to the belief that the economy will continue to improve.

Thank you for these questions which may be of interest to other subscribers. I created this video to discuss both how to create the chart and save it as a preset template for when you want to find it later which I hope will be of use to you.

Paul Tudor Jones on Jerome Powell

The market has long relied on the assumption that in a crisis the Federal Reserve will wade in to the rescue by boosting money supply and helping to reflate asset prices. However, it is not until a crisis occurs that investors truly knew whether Greenspan, Bernanke or Yellen had their backs. Jerome Powell is a lawyer, rather than an economist by training, and has yet to be tested. Therefore, investors do not know how he will react in a time of market stress. That remains an uncertainty that is being priced into this market.

Dogmas of the Quiet Past, Why Higher Rates are on the Horizon

Thanks to a subscriber for this article by Pamela Rosenau which appeared in Forbes. Here is a section:

For starters, history tells us that the dynamics of the supply and demand for money are relevant for determining an appropriate level for interest rates. The Federal Reserve is decreasing the supply of money by tapering their balance sheet, while the demand for money will increase with the latest bout of expansionary fiscal policy (i.e. tax reform). Professor Lars Oxelheim of the Financial Times, recently wrote how historical precedence has shown how this supply/demand shift can lead to significantly higher interest rates over a short period of time. Of course, this would impact the valuation of all asset classes as discount rates head higher. Market strategist Dave Rosenberg recently added that “we have a government policy that is aimed at pushing fiscal deficits higher and pulling trade deficits lower. Say this over and over again – these two goals can only co-exist with rising interest rates.”

Also, who is going to stroll in on their white horse and be the new big US treasury bond buyer? We know that the Fed is pruning their bond portfolio. After all, newly installed Fed Chairman Powell showed his true colors six years ago when he warned of the “Greenspan put” and its implicit encouragement of risk taking. Considering his concerns back then, I cannot imagine him being overly dovish given the valuation excesses in our environment today. Furthermore, the Chinese could play monetary hardball as a response to any hostile U.S. trade actions and choose to mitigate their participation in our auctions, thus causing a sudden spike or pernicious reset in interest rates. Frankly, Xi Jinping has a license to do whatever he wants at this point.

Let’s lay aside for a moment the arguments about whether inflation is in fact rising or not, or whether we can expect all of the deflationary forces that have contributed to the decades long decline of yields to continue. Let’s just devolve to the first principles of markets. There are more sellers than buyers.

Why Italian Elections Matter: A New Type of Populism Is Rising

This article by Giovanni Legorano for the Wall Street Journal may be of interest to subscribers. Here is a section:

The election is likely to prompt a question that could force 5 Star to define its future—and potentially that of Italy, too. Is it a governing force or simply a protest movement?

On one side are members, including Luigi Di Maio, the party’s 31-year-old candidate for premier, who are pushing it to join an alliance with mainstream parties. According to polls, 5 Star would receive about 27% of votes—not enough to govern alone, but potentially enough to play a major part in a coalition government.

Mr. Grillo has roundly rejected that scenario, saying that unless 5 Star wins an outright majority, it should remain an opposition party. Joining a coalition government is “like saying that a panda can eat raw meat,” he said in January. “We only eat bamboo.”

If no single party or coalition emerges with a parliamentary majority, Italy’s president could ask parties to attempt to form a grand, cross-party coalition that could have a limited lifespan.

This history of protest parties that enter government as part of a coalition is not favourable so Grillo is exhibiting political savvy in eschewing the temptation to enter power without a majority. However, Italy’s political system is so fractured that receiving a majority is a tall order which suggests the most likely scenario is another coalition that supports the status quo or limited reform at best. Nevertheless, until the event has passed it will continue to represent an uncertainty.

The Poison We Pick

This article by Andrew Sullivan for the New Yorker offers a particularly lucid account of the opioid epidemic in the USA. Here is a section:

One of the more vivid images that Americans have of drug abuse is of a rat in a cage, tapping a cocaine-infused water bottle again and again until the rodent expires. Years later, as recounted in Johann Hari’s epic history of the drug war, Chasing the Scream, a curious scientist replicated the experiment. But this time he added a control group. In one cage sat a rat and a water dispenser serving diluted morphine. In another cage, with another rat and an identical dispenser, he added something else: wheels to run in, colored balls to play with, lots of food to eat, and other rats for the junkie rodent to play or have sex with. Call it rat park. And the rats in rat park consumed just one-fifth of the morphine water of the rat in the cage. One reason for pathological addiction, it turns out, is the environment. If you were trapped in solitary confinement, with only morphine to pass the time, you’d die of your addiction pretty swiftly too. Take away the stimulus of community and all the oxytocin it naturally generates, and an artificial variety of the substance becomes much more compelling.

One way of thinking of postindustrial America is to imagine it as a former rat park, slowly converting into a rat cage. Market capitalism and revolutionary technology in the past couple of decades have transformed our economic and cultural reality, most intensely for those without college degrees. The dignity that many working-class men retained by providing for their families through physical labor has been greatly reduced by automation. Stable family life has collapsed, and the number of children without two parents in the home has risen among the white working and middle classes. The internet has ravaged local retail stores, flattening the uniqueness of many communities. Smartphones have eviscerated those moments of oxytocin-friendly actual human interaction. Meaning — once effortlessly provided by a more unified and often religious culture shared, at least nominally, by others — is harder to find, and the proportion of Americans who identify as “nones,” with no religious affiliation, has risen to record levels. Even as we near peak employment and record-high median household income, a sense of permanent economic insecurity and spiritual emptiness has become widespread. Some of that emptiness was once assuaged by a constantly rising standard of living, generation to generation. But that has now evaporated for most Americans.

The hollowing out of the middle class might be a handy soundbite but what if it can be taken literally? Escapism is part of the human condition and the spectrum of distractions we pursue is indeed influenced by the health of our individual social settings.

Will Quantitative Tightening (QT), which is deflationary in theory, be inflationary in practice?

Thanks to a subscriber for this article by Viril's Sokolof for 13d.com which may be of interest. Here is a section:

It is equally noteworthy that most of the peaks in M2 velocity shown in the prior chart, with a couple of exceptions, occurred when the U.S. dollar was in protracted bear markets from 1972 to 1980, 1985 to 1995 and 2002 to 2008. Moreover, the first and third of those down-cycles was marked by generally-rising yields on 10-year U.S. Treasuries. In other words, one could argue that rising UST yields were a symptom of capital flowing out of the dollar, which contributed to a higher cost-of-money and higher inflation.

These relationships shed some insight into the idea that tighter monetary policy — reflected in the slowing growth rate of M2 and the onset of the Fed’s balance-sheet reduction — is likely to be inflationary in practice. When money supply growth slows and the demand for funds increases — such as with the $1 trillion-plus fiscal deficits we wrote about last week — the conditions are ripe for an inflationary surge and a falling dollar. One could also argue that this will be good for real assets (which were hurt by QE during 2010 to 2016) but bad for financial assets (which benefited from QE).

The Velocity of Money is reported quarter in arrears so it tends to be a lagging indicator but it did turn upwards at the last reading in December. It stands to reason that if the economy has less slack and the government is about to blow out its deficits then inflationary pressures rise.

Email of the day on the potential for downtrends

Your recent assessments of the markets appear to be that a period of ranging is likely to be followed by markets going up again. Of course, whilst no one knows what the future will be, I wonder why you don't see the greater likelihood of markets turning down after some consolidation. With the amount of US debt increasing, interest rates increasing, and stock market levels already high by historical standards, are you not more concerned that markets, being forwards looking, might be more likely to head down than up? Esp. since markets struggle when interest rates go above 3%? I appreciate your talk of share rotation, but a rising tide lifts all boats and surely the opposite is true when markets tank?

Thank you for these questions which I think everyone asks from time to time. For someone in our position of attempting to forecast the outlook for markets the most important thing we have to remember is that markets rise for longer than they fall but when they fall they often do so quite quickly. However, they do not fall without first exhibiting topping characteristics.

Email of the day on stagflation

I have been a long-time subscriber and attended the Chart Seminar around ten years ago. Back then you were a young kid and David led the show. Showing no disrespect for David who admire greatly, you have become at least an equal when it comes to your daily audios. I found this weekend's long-term picture very interesting and well done. I think you have properly described where we are at presently and the likely outcomes in the medium and longer terms. I do get the sense over here in the US that we may be facing an environment of Stagflation. With rising inflation and what now looks like slower growth in the near term, combined with a shrinking Fed balance sheet and rising rates, we could be facing some real headwinds for equities. Can you share your insights on an environment of stagflation and what asset classes would generally over-perform and underperform if the past is a guide? Thank you and keep up the great work!

How Low Will Retail Go? Look at the Railroad

This article by Stephen Mihm for Bloomberg may be of interest to subscribers

And that is the likely fate of conventional retail. Like the railroad, there’s an extraordinarily surfeit of retail space built with little consideration of what the market will actually sustain; recent declines in the retail revenue per square foot in brick-and-mortar stores suggests that things are getting worse, fast. And like the railroad, there’s a new way of doing business on the block, except that instead of changing how we move people and goods, online retailing promises a new way of delivering them to the end consumer.

If the per capita retail footprint declined as much as the railroads did, it would fall all the way down to 2.82 square feet per capita. That’s a lot of empty malls and defunct big box stores, but retail won’t disappear any more than the railroads have gone extinct.

In fact, in 2014, the inflation-adjusted revenue that railroads earn per mile of track is 2.7 times what it was a century ago. More startling still, the so-called “ton miles” of freight carried on the nation’s railroads (a ton mile is one ton of freight carried one mile) has tripled since 1960, even as the total size of the operational railroad system has declined dramatically.

That points to the likely future of conventional retail: a drastic reduction in the per capita footprint, with the remaining stores capable of earning far more money per square foot. It’s not the brightest of futures. But it’s also not the end of the world.

Near where I live in Los Angeles, a large mall is close to shutting since it’s primary tenants, Macys and Nordstrom, have decamped to the newly refurbished Westfield mall in Century City near Beverly Hills. The two malls are about a mile apart but until a couple of years ago Macys seems to have been comfortable with the idea of having two large stores within close proximity of one another. In between the two malls the only businesses that have survived are universally service oriented. So, what is going to be done with all the empty commercial space sitting on valuable pieces of real estate?

Fiscal impulse update: Uncle Sam goes on a spending spree

The Dollar is weak, wages are rising, the participation rate has bottomed and unemployment is due to fall further. That is a recipe for inflation.

The surge in supply of Treasuries due over the course of the next few months and years, while the Fed is planning to further reduce the size of its balance sheet, represents additional downside pressure on Treasury prices over the medium term.

Cover title, initial cap only, goes

The cult of the equity is largely a US, UK and Australian phenomenon. In Europe, bonds are still a popular asset class for retail investors. Retail investors in Italy will remember the reverse convertible products peddled by banks over the last couple of decades. The quantity of such products on the books of Banca Monte dei Paschi di Siena was one of the primary contributors to the bank’s eventual demise. If anything, this helps to emphasise the point that there is no shortage of dodgy products in both the bond and equity markets that tend to gain popularity when there is a dearth of yield.

The EU's Real Rule-of-Law Crisis

This article by Simon Nixon for the Wall Street Journal may be of interest to subscribers. Here is a section:

Northern European countries will argue that the key to making the EU more resilient is to ensure that existing rules are more effectively enforced. For example, the German, Dutch and Finnish governments have called for changes to the way the EU budget is administered to make future EU funds conditional on member states undertaking reforms that would boost economic convergence.

That will put them on a collision course with countries in Eastern Europe who fear that the EU budget will be turned into another tool to allow Brussels to interfere in their domestic politics.

It will also put them on a collision course with the French government, which believes that simply relying on stricter enforcement of rules to rebuild trust isn’t sufficient.

French officials argue that the answer is deeper political integration based less on rules and more on institutions. They point to the creation of the European Central Bank as an example of a significant pooling of sovereignty that was greeted with suspicion at first but has won broad public trust by operating independently and decisively. They say that a similar leap is needed now.

But to succeed, France will need to convince skeptical partners that any new institutions can be trusted to apply EU rules consistently and ensure member states respect their obligations—rather than deepen what has become the EU’s true rule-of-law crisis.

The European Union has one set of rules for large countries and quite another for small countries. At the same time the national champions of large countries can act with impunity while just about everyone else is expected to abide by the mille feuille of bureaucracy spewing from Brussels.

Tesla doesn’t make money so every source of fresh capital is important to the company. Having tapped the bond and equity markets the company began taking deposits for its Model 3 which the company counts as revenue. One might rightfully question the accounting integrity of that decision since these are deposits based on the assumption a car will be delivered.

The Key to Tesla's First-Quarter Output Goal Is Still in Germany

This article by Dana Hull for Bloomberg may be of interest to subscribers. Here is a section:

Tesla Inc. has all the tools to meet its planned Model 3 production rate in the first quarter. The only problem is they’re still in Germany.

The electric-car maker -- which is still targeting about 2,500 of the cars a week by the end of March -- has designed a new automated system for module production for its battery factory near Reno, Nevada. The line’s already working at its German Grohmann unit but it needs to be shipped to the U.S. next month before it can go into use, Chief Executive Officer Elon Musk said.

“That’s got to be disassembled, brought over to the Gigafactory, and re-assembled and then brought into operation at the Gigafactory. It’s not a question of whether it works or not. It’s just a question of disassembly, transport and reassembly,” he said on a conference call Wednesday. Once that milestone’s completed, Tesla will next need to fix material handling constraints at its Fremont, California, assembly plant before it can reach its 5,000-a-week goal by the end of June.

Tesla -- which has pushed back its Model 3 production targets several times -- is banking on the more affordable model to propel it from niche electric-car maker to mass-market manufacturer. The slower ramp means less money is coming in the door from customers taking delivery, and Wall Street is watching closely for any signs the targets could slip again.

The launch of the SpaceX' super heavy rocket was delayed on multiple occasions but suddenly everything seemed to go right ahead of the earnings announcement the day after. I don’t think I’m the only one who doesn’t see this as a coincidence. Tesla is attempting to build a world class heavy manufacturing centre from scratch which is no simple task and in doing so faced much greater competition than SpaceX does in launching rockets.

Gilts Tumble as Bank of England Signals Faster Hiking Pace

This article by Charlotte Ryan and John Ainger for Bloomberg may be of interest to subscribers. Here is a section:

The central bank left its rate at 0.5 percent as expected and raised growth and inflation forecasts. While the pound was boosted by the central bank’s tone, sterling could see gains tempered by the fact the BOE’s policy path remains closely tied to progress in the Brexit talks, according to Viraj Patel, a currency strategist at ING Groep NV.

In a press conference, Governor Mark Carney said that while the bank sees more tightening than it did in November, this was a “crucial” year for the Brexit negotiations and everyone would be better informed next year, which would have an effect on the central bank’s thinking. Rises will be gradual and the bank is not tied to a specific rate path, he said.

It was a “Brexit-contingent hawkish signal,” said Patel, among the most bullish forecasters on the pound. The greater prospect of a rate increase in coming months “reinforces our $1.45 target for cable in the first quarter of 2018.”

Jacob Rees-Mogg has the wonderful luxury of not holding a ministerial position and can therefore say whatever he wishes. That straight-talking manner has made him a champion of the Conservative’s Brexit camp. Theresa May continues to walk a fine line between appeasing warring factions within her own party while also needing to keep Northern Ireland’s DUP onside in order to maintain her majority.

Treasury Market's Long-Dormant Term Premium Is Finally Reviving

This article by Liz Capo McCormick and Luke Kawa for Bloomberg may be of interest. Here is a section:

“We remain of the view that the U.S. term premium is still too low when conditioned against the macro outlook, and the uncertainty around it,” Francesco Garzarelli and his fellow strategists wrote in a note Tuesday. “We recommend preserving a short duration exposure and expect the rebuild of the term premium to lead to a steeper” U.S. yield curve.

Goldman Sachs issued a short recommendation for 10-year Treasuries in November, which the strategists maintain. The firm’s model for fair value -- given economic fundamental and the expected pace of Fed tightening -- has the note at 3.09 percent, compared with about 2.8 percent now.

The term premium is the extra compensation that buyers demand to hold longer-maturity debt instead of a succession of short-term securities year after year. A widely used valuation tool, it tumbled across world markets in the wake of the financial crisis as the Fed and its counterparts bought debt as part of stimulus measures.

The 10-year Treasury term premium is negative 0.29 percentage point, up from a record low of negative 0.84 percentage point in 2016. As the name implies, it’s normally positive.

Its increase in 2018 marks a departure from its typical downward trend during Fed tightening cycles. But much is different this time around -- namely, the central bank’s balance-sheet tapering.

The Fed is buying fewer bonds and the Treasury is attempting to issue more. That is a recipe for yields to move higher. The imposition of deficit fueled tax cuts has reignited the prospect of the bond market taking issue with fiscal profligacy while the prospect of an additional infrastructure bill is likely to have an even greater deleterious effect.

Risk Parity and new Central Bankers?

Ray Dalio’s Bridgewater, one of the most successful hedge funds in the world, originated ‘risk parity’ to take advantage of the fact that bonds and the stock market seldom move in the same direction.

The whole rationale for the strategy is that when the stock market pulls back, investors will naturally seek a haven in the bond market. Dalio might have pioneered the approach but it has subsequently been employed across a wide swathe of the financial sector. A conservative estimate is more than $500 billion is devoted to this strategy.

How have traditional safe haven assets been performing?

Three points agitated investors on the 30th and contributed the largest decline on the stock market seen in months. Amazon, JPMorgan and Berkshire Hathaway announcing a plan to reduce healthcare costs for their employees hit the healthcare sector, there were fears that President Trump’s State of the Union address would focus on trade, the Dollar and China but the speech was noticeably light on these topics. Meanwhile any investment manager looking to sustain a 60/40 split in bonds to equities had until today’s close rebalance some of their overweight equities into bonds.

Email of the day on what to do in the third psychological perception stage of a bull market:

After listening to the latest Long-Term Outlook broadcast in which you reiterated your view that we were in the final phase of a cyclical bull market and that while it was a time to be watchful, it was not a time to sell, I could not help thinking back to 2008 when David, in his daily audios, said on several occasions that he did not think the sub-prime crisis would amount to much.

Unless I'm much mistaken, he continued to make this comment until at least June. Around June 2008, I bought Citibank at $33 (equivalent to $330 today) yielding 7.5% - a bargain. They fell to $27 and I bought some more. Unfortunately, I lacked the guts to buy when they fell to $1 but I did add to my holding as the price steadied and rose - not much because I remained cautious (scared to death to be more truthful). Only this year has my Citibank investment moved into profit. I make these comments because as Sam Goldwyn famously said, 'forecasting is difficult, particularly when it's about the future'.

Like anyone else, I have no clue as to the timing, the depth or the length of the next correction or crash. However, without income flowing in from any source other than investments, I am now beginning to prune - or intending to prune: selling, as you know, is harder than pulling hens' teeth.

Why do I want to prune now? Because I do not want to be trying to raise cash when markets are plummeting. Some would argue that one should just hold through the corrections and crashes and I would agree with that - to an extent. My caveat would be that one must have cash to take advantage of the market swoons when they occur. If one remained fully invested from 1999 to the current time and lacked cash to add to the market in 2009 or 10, one's returns would not look overly good. So, I intend to increase my cash reserve now, probably top slicing tech, resources and China. If I wait for someone to ring a bell, or point out that chart patterns are deteriorating, the probability is that it will be too late.

Thank you for this generous email which highlights a range of emotions and experiences that I believe will be valuable to the Collective. I agree breaking up is hard to do but the best time to take profits is when the market is accelerating higher. At least when you are taking profits, you are not buying more which is one of the biggest mistakes a long-term investor can make in an accelerating market.

The USA led the world into recession in 2008 and out of it onto an historically lengthy expansion in 2009. The Federal Reserve started out on the road to normalizing policy last year and fiscal stimulus will be picking up some of the slack in monetary accommodation this year. The above statistics suggests at least some Asian countries are now following a similar trajectory.

German Yields Surge as Draghi Avoids a 'Strong Swipe' at Euro

This article by John Ainger for Bloomberg may be of interest to subscribers. Here it is in full:

German benchmark yields climbed to the highest level in more than two years after European Central Bank President Mario Draghi disappointed investors who had expected him to take a tough stance against recent euro strength.

Peripheral sovereign bonds led declines across the currency bloc as Draghi warned that foreign-exchange volatility required monitoring, but also noted that economic growth could surprise to the upside. With comments on the shared currency identified as the main barometer of the ECB’s thinking before the meeting, Draghi’s reluctance to take a tougher stance on the euro triggered the selloff in government securities, according to Toronto-Dominion Bank.

Draghi didn’t take a “strong swipe at euro strength” and “that has bled into rates,” said Richard Kelly, Toronto- Dominion’s head of global strategy. “He upgraded growth and hasn’t yet said anything new on inflation. So it all adds up to a slight drift higher for rates.”

German 10-year bund yields climbed four basis points to 0.63 percent as of 2:34 p.m. in London, after touching 0.64 percent, the highest since December 2015. Those on Italian peers increased six basis points to 1.96 percent, while comparable Spanish yields jumped six basis points to 1.42 percent.

It’s a testament to how low yields are when a 2-basis point move can be described in headlines as a surge. Bund yields are now testing the upper side of a yearlong range and will need to sustain the move above 0.6% to confirm a return to demand dominance.

Bond ETFs Awash in Pain May Be Red Flag for Risk Appetite

This article by Dani Burger and Sid Verma for Bloomberg may be of interest to subscribers. Here is a section:

“The tax package is probably giving institutional investors more confidence about the shape of corporate balance sheets,” said Matt Maley, a strategist at trading firm Miller Tabak + Co. “Thus they might be making up for the selling that is coming from these products geared towards individuals, who are worried about the rise in government yields.”

U.S.-listed corporate bond ETFs are headed for a second consecutive month of outflows, the first time that’s occurred in at least seven years. The pain is across ratings. The iShares iBoxx Investment Grade Corporate Bond ETF, LQD, had the biggest day of losses last week since 2016, while BlackRock’s high-yield equivalent, HYG, is in the midst of its biggest two-month outflows on record.

If the withdrawals are a symptom that retail funds are losing their taste for fixed-income, the impact could be far-reaching. A tweet from DoubleLine Capital LP co-founder Jeffrey Gundlach Thursday -- who has previously warned underperformance may portend a selloff for risk assets -- noted the gap between junk ETF prices and stock gains.

On Bloomberg TV yesterday I was asked to comment on the uptick in high yield spreads. It was unfortunate that I did not have access to the chart, because I was speaking into a camera, so I had to rely on memory. However, I find it interesting that the junk bond market is garnering attention right now because the move has been so minor.

Doubling of U.S. Bond Supply Seen as a Threat to Global Rally

This article by Sid Verma for Bloomberg may be of interest to subscribers. Here is a section:

A “dramatic” increase in U.S. bond supply over the next year risks unhinging global markets from their bullish foundations, warns Torsten Slok at Deutsche Bank AG.

The supply of U.S. government debt will almost double to $1 trillion this year to finance a widening budget deficit as the Federal Reserve whittles down its holdings. Unless new buyers emerge, the overhang could be far-reaching.

“If demand for U.S. fixed income doesn’t double over the coming years then U.S. long rates will move higher, credit spreads will widen, the dollar will fall, and stocks will likely go down as foreigners move out of depreciating U.S. assets,” the chief international economist at the German lender wrote in a note Tuesday. “And this could happen even in a situation where U.S. economic fundamentals remain solid.”

Those fears aren’t shared widely on Wall Street, where spreads on corporate bonds have sunk to 2007 lows and bullish indicators abound. The rally in credit appears relentless, retail demand for bonds is insatiable and tax cuts may reduce corporate borrowing.

Commercial banks, emerging-market reserve managers and pension funds are all set to plug the $1.1 trillion hole in global bond demand left by central banks this year, according to JPMorgan Chase & Co.

The US Treasury has a great deal of debt that matures in 2018 as we approach the 10-year anniversary of the global financial crisis. That is at least part of the reason the Federal Reserve is paring its holdings of debt, with plans to roll-off about half of the total maturing this year. Nevertheless, that still represents over $200 billion, in addition to whatever is required to fund the deficit, that needs to be absorbed by the market this year.

Email of the day China, Currencies, Inflation and Gold

In the video today, you emphasized the significance of recent moves by China regarding its currency and inflation. These issues were discussed in length in a Mises Institute report which will be of interest to many readers.

Thank you for this interesting article which is representative of monetary conservativism that is a central theme in decrying the loss of purchasing power in fiat currencies since the abandonment of gold as a monetary base.

Euro Tests Three-Year High as End-of-Stimulus Fear Batters Bonds

This article by John Ainger and Samuel Potter for Bloomberg may be of interest to subscribers. Here is a section:

The currency jumped, sapping stocks, and bonds slid as a slew of data signaled a potential uptick in inflation in the euro area, after manufacturing growth accelerated to a record in December. The numbers followed comments at the weekend from European Central Bank policy maker Benoit Coeure, who said that unless inflation disappointed there’s a “reasonable chance” the central bank’s extension of QE in October could be the final one.

While Coeure didn’t mention the exchange rate, his comments were a boon for euro bulls and coincided with a period of ongoing dollar weakness. The common currency’s strength is translating into a painful start to the year for Europe’s export-heavy stock markets, while bonds have picked up where 2017 left off, with benchmark German bund yields rising to the highest since October.

“The ECB suggestion that bond buying will not be extended is likely behind the recent push higher in the euro,” said Neil Jones, head of currency sales at Mizuho Bank Ltd. in London. “My sense is the euro will extend beyond its three-year high in the next two weeks.”

If I had to pick one market to watch on a daily basis in 2018 it is German Bunds. Germany has benefitted enormously from the ECB’s bond buying program and has enjoyed borrowing costs that were previously unimaginable. With negative yields on bonds out to seven-year maturities there is significant scope for re-rating when the ECB eventually exits its program.

Italy's Gentiloni Says Election Campaign Is 'Imminent'

This article by John Follain, Lorenzo Totaro and Chiara Albanese for Bloomberg may be of interest to subscribers. Here is a section:

The euro zone’s third-biggest economy, whose recovery is trailing most of its peers, risks a hung parliament after the ballot. Opinion polls show the anti-establishment Five Star Movement, which wants a consultative referendum on abandoning the euro if European Union treaties aren’t renegotiated, leading Gentiloni’s Democratic Party and groups in a possible center- right coalition that would include former Premier Silvio Berlusconi’s Forza Italia.

But neither Five Star, the Democrats headed by former Prime Minister Matteo Renzi, nor the center-right bloc would win a parliamentary majority, according to the surveys. A possible “grand coalition” of the Democrats and Forza Italia would not have a majority either.

“It’s virtually certain that we won’t have a clear majority,” said Sergio Fabbrini, director of the school of government at Luiss University in Rome. “The talks to verify whether a new majority can be formed could last until the summer. In Germany, the talks have dragged on for ages, and in Italy we may end up with about twice as many parties in parliament as in Germany.”

Political sclerosis is nothing new for Italy. With little chance of a clear winner from elections, the country will continue to be rule taker rather than a leader in the discussions about how the EU can be reformed, which Macron wants to get started.

When Will the ECB Pull Its Trillions From the Markets?

This article by Jana Randow, Jeremy Scott Diamond and Hayley Warren for Bloomberg from a month ago is equally relevant today and piqued by interest. Here is a section:

After three years of asset purchases, negative interest rates and cheap loans, the European Central Bank is finally confident that it has beaten the risk of deflation in the euro area. Now it’s time to start thinking about how to unwind those extraordinary measures.

It won’t be simple. The ECB’s mandate is to keep inflation just below 2 percent, but to judge its progress it looks at a range of key economic and market indicators.

In the first step toward the exit, policy makers decided to reduce monthly asset purchases by half starting in January and extend it for at least another nine months.

The Federal Reserve is now shrinking its balance sheet, albeit slowly. The Bank of Canada has raised rates, the Bank of England reversed an interest rate cut while the ECB is tapering, China is holding at neutral policy on aggregate while Japan is the only major economy still engaged in monetary and fiscal stimulus. It is reasonable to say that synchronized global economic expansions is one the way to replacing synchronized global monetary expansion.

Financial Markets in 2018: The Times They Are A Changing

Thanks to a subscriber for this article by Pamela Rosenau for Forbes which may be of interest. Here is a section:

As correlations among stocks and other assets classes break down, there will be a significant divergence in the performance of “quality” assets versus “junk” assets. A prudent money manager should be prepared for this market shift by focusing on shorter duration assets, which goes for both credit and equities. I expect longer duration equities, such as growth stocks with lower near-term earnings to underperform more value oriented stocks such as consumer staples, telecom, and energy sectors, on which I have focused. Today’s market appears to be the inverse image to the early 1980s. Back then, investors were misled into hiding out in cash as stocks were perceived as too expensive in a high interest rate environment. Today, very few hold cash as stocks appear cheap relative to low bond yields. This is a backward looking strategy derived from a relative value argument that is no longer operable. I suggest more than a little risk aversion, as I have maintained, would be prudent in times like this. As I have often said -- preserving capital is paramount, not winning friends.

Money has been pouring into ETFs over the last couple of years which is a testament to the success of the low fee argument, against a background where the success of momentum strategies has reduced the allure of stock picking. The success of the ETF business has contributed to the consistency of the trends evident on the primary Wall Street indices and the low volatility condition that has prevailed over the last six months in particular.

ECB's Weidmann Predicts Wage Gains as He Seeks QE End-Date

This article by Jana Randow and Paul Gordon for Bloomberg may be of interest to subscribers. Here is a section:

European Central Bank policy maker Jens Weidmann reiterated his call for a definite end-date for the institution’s bond-buying program, a refrain that looks likely to gain traction among his colleagues next year.

Saying that domestic price pressures should strengthen as wage growth improves, he said they are “therefore on track toward our definition of price stability.”

While policy makers meeting last week reaffirmed their commitment to buy debt until September “or beyond,” officials including at least half the six-member Executive Board have signaled they’re willing to rein in expectations for another extension. The euro area is currently undergoing the broadest economic expansion in its history, and the ECB this month upgraded its growth forecasts for the bloc.

“A faster conclusion of net asset purchases and a clearly communicated end date would have been reasonable,” Weidmann, who also heads Germany’s Bundesbank, told reporters in Frankfurt late Monday.

Despite the upturn, the ECB remains well short of its inflation goal of just under 2 percent -- and Germany is a prime example of the conundrum. There, record-low unemployment and economic growth above its long-term potential has still failed to generate much in the way of wage growth. Weidmann said he’s confident that will soon change.

“We don’t get involved in wage bargaining and respect the independence of bargaining partners. But we expect that the increased capacity utilization and regionally appearing bottlenecks in some labor markets will lead to somewhat higher wage pressure,” he said. “That’s a projection, not a recommendation.’’

It’s considered toeing the party line for a German central banker to talk about curtailing quantitative easing and raising interest rates. However, there is no denying that the European economy is benefitting both from the ECB’s purchase program and the return to synchronized global growth. A partial counter to that argument is Europe has some of the oldest average populations in the world which represents a challenge for stoking inflationary pressures.

China's Banks Need More Capital After Credit Boom, IMF Says

Thanks to a subscriber for this article from Bloomberg News which may be of interest to subscribers. Here is a section:

President Xi Jinping has highlighted financial stability as a top priority. People’s Bank of China Governor Zhou Xiaochuan warned in October about the risk of a ‘Minsky moment,’ or a sudden collapse of asset values. Financial watchdogs last month promised to overhaul regulation of asset-management products, which hold about $15 trillion and are seen as a key threat to stability.

Speaking to media on Thursday on a video call, the IMF’s deputy director of monetary and capital markets, Ratna Sahay, said China’s financial system held three main risks. She pointed to an increase in credit that in other countries has been linked to financial distress. An increasingly complex and opaque financial system makes it hard to identify risks, and implicit guarantees encourage excessive risk-taking, she said.

Credit growth needs to slow, guarantees should be gradually removed, and banks need more capital during that process, Sahay said. “Banks need to have some buffers in order to protect against any possible distress that might happen,’’ she said.

Financial stability is a priority for every country and just about everywhere has its own version of implicit guarantees. We can only imagine what would happen in the USA if the now explicit guarantee behind Fannie Mae and Freddie Mac were removed. What state would the financial sector be in now if the EU and UK had not stepped in to backstop it during what was dubbed a sovereign debt crisis but was in fact a cross border banking sector calamity?

How the Flynn Charges Box In Trump

This article by Noah Feldman for Bloomberg may be of interest to subscribers. Here is a section:

The content of the Flynn-Kislyak conversations deepens the narrative that special counsel Robert Mueller has been building: Earlier guilty pleas revealed Russian efforts to connect with the Trump campaign; this one reveals official contacts between the Trump team and Russia after the election -- contact significant enough for Flynn to lie to the FBI about.

The fact that the lies concern Russia makes it politically harder for Trump to fire Mueller or to pardon Flynn than if the charge had involved Flynn's other legal woes over his unreported lobbying for Turkey.

The Mueller investigation of ties between the Russian government and the Trump administration represents a potential powder keg for the political arena which could potentially bleed into the markets. It is looking increasingly likely that the tax legislation will get passed ahead of the release of whatever conclusions the investigation reaches but it is a wild card that could contribute to volatility.

A section from a note by Russell Napier is posted in the Subscriber's Area.

U.S. Stocks Gain on Tax Outlook as Treasuries Drop: Markets Wrap

This article by Brendan Walsh for Bloomberg may be of interest to subscribers. Here is a section:

An up-or-down vote on the Senate’s tax bill could happen before the end of this week. While McCain’s support helped bring the measure one step closer to passing, Republican Senator Susan Collins of Maine said it “would be very difficult” for her to support the proposal in its current form. The party can only afford to lose two of its 52 members to pass the bill without Democratic support. Bob Corker of Tennessee, Jeff Flake of Arizona, James Lankford of Oklahoma and Ron Johnson of Wisconsin are all seen as potential “no” votes.

Data showed U.S. consumer spending settled back in October to a still-decent pace after the biggest increase since 2009, as a post-storm surge in auto sales cooled. Incomes remained robust and inflation showed progress toward the Federal Reserve’s goal. Treasuries sank, driving the benchmark 10-year yield to the highest in a month.

The most dominant strategy evident in the US equity market this year has been an automated process to buy the dips. What has become obvious over the last few months is that what is considered a dip is getting progressively smaller.

After Sudden Rout, China Stock Traders Question Beijing Put

This article from Bloomberg News may be of interest to subscribers. Here is a section:

For Sun Jianbo, president of China Vision Capital Management Co. in Beijing, valuations among large-cap shares are too expensive for state-backed funds to intervene.

The CSI 300 traded at its highest level relative to the broader Shanghai Composite Index in at least 12 years at the start of this week as investors flocked to large caps such as Moutai and Ping An Insurance (Group) Co.

"There’s no need to prop up the market yet," Sun said. "A lot of big caps are still expensive and it would do more harm than good to state-backed funds if they buy now."

The divergence between large-cap shares and the rest of the market may be one reason why the government took aim at Moutai. Before Xinhua warned last week that gains in the liquor maker were excessive, the stock had more than doubled this year.

Following the botched introduction of options trading in 2015 the Chinese administration introduced new rules on disclosures and selling by company principles. It also banned short selling for a time. Through steady purchases by various state-owned vehicles, they manufactured the slow and steady pace of the stock market’s advance since the low in early 2016.

Email of the day on the next crash

Thank you for this article which may be of interest to subscribers. It is always a useful exercise to contemplate the end of the financial world but in the full knowledge it doesn’t happen all that often. Niall Ferguson does a good job of articulating the potential causes of future problems in this article which is sure to garner attention for his new book.

Goldman Sachs Sees Four 2018 Fed Rate Hikes as U.S. Growth Gains

This article by Brendan Murray for Bloomberg may be of interest to subscribers. Here is a section:

The U.S. jobless rate, which was 4.1 percent in October, may reach 3.5 percent in late 2019, Goldman predicted. That would be the lowest level since the late-1960s.

“Our projections would imply an evolution over the current cycle from the weakest labor market in postwar U.S. history to one of the tightest,” the economists said in a summary of their report. “We expect that a tight labor market and a more normal inflation picture will lead the Fed to deliver four hikes next year.”

That’s one more rate increase than the median forecast of Fed officials, and more than financial markets are currently pricing in. One of the reasons why Goldman Sachs economists said they disagree with market expectations is “we see little evidence that soft inflation is structural in nature.”

The USA’s economic expansion might be modest by historical standards but it is still one of the longest in history. The prospect of adding a fiscal stimulus when growth is already mature and unemployment low is the epitome of procyclical policy and increases the likelihood that inflation will increase.

Russell Napier: Debt Deflation Worries Are Starting to Rise Again

Thanks to a subscriber for this article from Financial Sense which may be of interest to subscribers. Here is a section on the Velocity of Money:

Though there is an overall tendency for velocity of money to fall over time, Napier noted, the accelerated decline we’ve seen in recent years is due to the nature of the money that is being created. This money primarily takes the form of bank reserves, which are not inherently fungible and are now stuck in the banking system.

Banks have chosen not to increase the size of their balance sheets and create deposits, which is the money that circulates in the actual economy, as opposed to the asset economy. This is why Napier thinks the velocity of money has fallen.
“There’s a form of money there that is stuck in the ‘asset ghetto,’ if you like, and not yet spreading out to normal GDP,” he said.

This plays in part into the assumption most people make that the world is awash in money. While there is a lot of money in the asset markets, the reality is that M2 growth in the United States is 5 percent, which is one of the lowest levels recorded in the past 30 years, Napier noted. Apart from the 2008 to 2009 crisis, we’re back to very low levels of total money creation.
This is true of other countries, as well. China is close to a new record low in the growth of its money supply. India is also showing levels of growth in its money supply not seen since 1963.

The Velocity of M2 is at a record low based on the last update of September 30th. If Russell Napier’s contention the Index has plumbed new depths since 2010 because of stranded reserves at banks then the reduction of the Fed’s balance sheet could have a positive effect by pushing responsibility for credit creation onto the banking sector.

America's "Retail Apocalypse" Is Really Just Beginning

This article by Matt Townsend, Jenny Surane, Emma Orr and Christopher Cannon for Bloomberg may be of interest to subscribers. Here is a section:

Until this year, struggling retailers have largely been able to avoid bankruptcy by refinancing to buy more time. But the market has shifted, with the negative view on retail pushing investors to reconsider lending to them. Toys “R” Us Inc. served as an early sign of what might lie ahead. It surprised investors in September by filing for bankruptcy—the third-largest retail bankruptcy in U.S. history—after struggling to refinance just $400 million of its $5 billion in debt. And its results were mostly stable, with profitability increasing amid a small drop in sales.

Making matters more difficult is the explosive amount of risky debt owed by retail coming due over the next five years. Several companies are like teen-jewelry chain Claire’s Stores Inc., a 2007 leveraged buyout owned by private-equity firm Apollo Global Management LLC, which has $2 billion in borrowings starting to mature in 2019 and still has 1,600 stores in North America.

Just $100 million of high-yield retail borrowings were set to mature this year, but that will increase to $1.9 billion in 2018, according to Fitch Ratings Inc. And from 2019 to 2025, it will balloon to an annual average of almost $5 billion. The amount of retail debt considered risky is also rising. Over the past year, high-yield bonds outstanding gained 20 percent, to $35 billion, and the industry’s leveraged loans are up 15 percent, to $152 billion, according to Bloomberg data.

Even worse, this will hit as a record $1 trillion in high-yield debt for all industries comes due over the next five years, according to Moody’s. The surge in demand for refinancing is also likely to come just as credit markets tighten and become much less accommodating to distressed borrowers.

One of Warren Buffett’s most colourful adages is “you don’t know who has been swimming naked till the tide goes out” A great many companies have survived with high debt loads because liquidity was abundant, interest rates were at rock bottom levels and access to credit was easy. Until recently, refinancing has been easy which allowed companies to pile on additional debt. An obvious point is that highly leveraged companies are heavily exposed to refinancing issues as interest rates rise.

Venezuela Will Seek to Restructure Debt, Blaming Sanctions

This article by Katia Porzecanski, Patricia Laya, Ben Bartenstein, and Christine Jenkins for Bloomberg may be of interest to subscribers. Here is a section:

Prices on PDVSA’s $3 billion of bonds maturing in 2027 were quoted at 20 cents on the dollar at 9:23 a.m. in London, according to pricing source CBBT. Venezuelan government bonds maturing in 2018 slid 16 cents on the dollar to 63 cents, while longer-maturity debt was little changed.

Even after the oil producer known as PDVSA made an $842 million principal payment Oct. 27, the nation is behind on about $800 million of interest payments. All told, there’s $143 billion in foreign debt owed by the government and state entities, with about $52 billion in bonds, according to Torino Capital.

Sanctions imposed in August by the U.S. have made it difficult to raise money from international investors, and effectively prohibit refinancing or restructuring existing debt, because they block U.S.-regulated institutions from buying new bonds. It’s an unprecedented situation for bondholders, who have limited recourse as long as sanctions are in effect.

“I decree a refinancing and restructuring of external debt and all Venezuelan payments,” Maduro said. “We’re going to a complete reformatting. To find an equilibrium, and to cover the necessities of the country, the investments of the country.”

$60 is a big level for many higher cost private sector oil producers. It’s a number many companies have quoted as they struggled with cutting costs while prices traded below economic levels. Their fortunes are improving now that prices are at two-year highs. Venezuela’s breakeven is well above current levels so the recent rally is less of a salve, while bond payments are a constant drain on revenues.

Email of the day on low interest rates driving the stock market

I was listening to a podcast at Epsilon Theory and they were discussing their observation of S&P EBITDA growth being significantly lower than Net Income growth. This would signify that the artificially low interest rates being the prime driver of earnings which poses a scary scenario. I can't seem to find an updated chart. Can you add to the Chart Library? Thank you!

Thank you for this question but I’m afraid the universe of fundamental statistics we have available to post in the Chart Library is rather limited so creating the spread between EBITDA and Net Income is not possible.

BOE Rate Increase May Not Be Enough to Revive Brexit-Vexed Pound

This article by Charlotte Ryan for Bloomberg which offers a summary of thinking on the Pound heading into the BoE meeting on Thursday. Here it is in full:

The Bank of England may increase interest rates this week for the first time in more than a decade, but that won’t be enough to buoy the pound, according to strategists.

Markets almost fully price in a 25-basis-point increase in the BOE’s key rate on Thursday, meaning investors are ill- prepared for a disappointment. Should Governor Mark Carney and fellow policy makers keep policy on hold, or deliver a one-time hike that merely reverses the emergency cut after the Brexit vote, sterling could add to the last two weeks’ declines, according to Ross Walker, an economist at NatWest Markets.

The U.K. currency has declined 1.8 percent against the dollar during October as concerns about the lack of progress in Brexit negotiations weighed on investor sentiment. It snapped a two-day decline on Monday, gaining 0.3 percent to $1.3161 as of 9:11 a.m. The yield on 10-year U.K. government bonds fell 1 basis point to 1.34 percent.

“Sterling needs a hawkish hike in order to rally,” said Walker. “The pound could come under pressure” otherwise, he said.

While money-market pricing suggests an 89 percent probability that the Monetary Police Committee will tighten on Thursday, banks including Credit Suisse Group AG and Barclays Plc expect a “one-and-done” move. Investors will look to the language of the MPC minutes, vote split and the quarterly Inflation Report to gauge the policy outlook further ahead.

“I’d prefer to go into the meeting” with a short position on sterling, said Steven Barrow, head of currency strategy in London at Standard Bank. “There is a reasonable enough chance they don’t raise rates. We’ll have to see what comes out from the statement the bank puts out.”

The bond market has pretty much priced in the potential for the Bank of England to raise rates this week, with 3-month yields rising from a low in July of 0.12% to 0.41% today. Perhaps the biggest question is not so much whether they will raise rates but rather will they manage to sustain the hike and whether they will raise again?

Venezuela's Behind on Its Debt and Facing Two Huge Bond Payments

Venezuela could still also make the payments on time. While $10 billion in foreign reserves isn’t much for a country that now owes some $140 billion to foreign creditors, it’s still enough to pay the bills for a while.

And the Maduro government has surprised the bond market before, making payments the past couple years that many traders had anticipated would be missed. Some of those now betting that these next two payments will also be made actually point to the $350 million currently overdue on the other notes as an encouraging sign. Those arrears indicate, they contend, that officials are prioritizing the payment of bonds with no grace period at the expense of those they can put off without penalty.

Even if Venezuela can make the payments due this year, investors say that, unless oil prices stage some sort of miraculous comeback, they still see default as an inevitable outcome. Credit-default swaps show they’re pricing in a 75 percent chance of a PDVSA default in the next 12 months and 99 percent in the next five years.

Venezuela represents a problem for bond investors because it could either be a one-off default or be the thin end of the wedge for distressed energy producers. The fact PDVSA sinkable bonds are now trading at a spread of 526 basis points, versus 200 last week, suggests investors are increasingly skeptical the government is going to be able to make principal payments when they mature on November 2nd.

Why We Don't Trust Government Inflation Statistics...

Thanks to a subscriber for this interesting report from Oppenheimer which may be appreciated by the Collective. Here is a section:

We all know that nominal interest rates are a function of real interest rates and inflation expectations. The nub of our argument is that the consumer price index (CPI) as measured by the Bureau of Labor Statistics (BLS) sharply understates what bond investors should incorporate into their inflation expectations.

The first component of our three-part argument is that CPI measures inflation where the people are, not where the money is. That is an appropriate stance for BLS since CPI is used to set government benefit levels, but consider that the top 20%, who effectively own all the bonds, generate as much consumer spending as the lower 62%. The basket of goods that 20% buys likely differs significantly from the basket of the average person.

Second, we look at the healthcare anomaly. Healthcare accounts for 17.7% of GDP and 14.5% of the S&P 500 but only 8.5% of CPI. Most private sources estimate healthcare costs have been increasing by ~6%+ in recent years, but BLS puts the number at 2.8%. A recent study found that the average health insurance plan now costs ~$19K (with ~$6K from the employee), but healthcare insurance is just 1.004% of CPI.

Third, in looking at how CPI is calculated, we suspect there is a "streetlight effect," where one searches where the light is good rather than where the sought object is likely to be. In the case of CPI, we suspect they measure what is easily quantified. There is incredible granularity on the cost of apples, bananas and peanut butter but only big sweeping categories for healthcare and housing.

The bottom line is that we think CPI substantially understates the inflation expectations that investors should incorporate into the pricing of bonds and that long-term rates should increase. One does not have to believe this to own bank stocks as they remain cheap in any case at a 66% relative P/E, but if we are correct about CPI, the upside should be even better.

Anyone who lives in the real world and pays their own bills, mortgage and taxes knows inflation is understated. Additionally, since government spending is integrally tied to official statistics, politicians have an interest in the understatement persisting not least because fiscal deficits are already wide. However, it is reasonable to conclude that we have had such an uptick in reactionism against the status quo is because consumers have direct experience of inflation which the statistics refuse to acknowledge.

The World Turned Upside Down

Thanks to a subscriber for this edition of John Mauldin’s note which may be of interest. Here is a section:

* the excess liquidity provided by the world’s central bankers,
* serving up a virtuous cycle of fund inflows into ever more popular ETFs (passive investors) that buy not when stocks are cheap but when inflows are readily flowing,
* the dominance of risk parity and volatility trending, who worship at the altar of price momentum brought on by those ETFs (and are also agnostic to “value,” balance sheets,” income statements),
* the reduced role of active investors like hedge funds – the slack is picked up by ETFs and Quant strategies,
* creating an almost systemic “buy on the dip” mentality and conditioning.
when coupled with precarious positioning by speculators and market participants:
* who have profited from shorting volatility and have gotten so one-sided (by shorting VIX and VXX futures) that any quick market sell off will likely be exacerbated, much like portfolio insurance’s role in a previous large drawdown,
* which in turn will force leveraged risk parity portfolios to de-risk (and reducing the chance of fast turn back up in the markets),
* and could lead to an end of the virtuous cycle – if ETFs start to sell, who is left to buy?

How Far Can the Catalan Rebellion Go?

This article from Bloomberg Businessweek may be of interest to subscribers. Here is a section:

Rajoy would need someone reliable to enforce the ruling. With the loyalty of the Catalan police force in doubt, that probably means the estimated 10,000 national police and Civil Guard officers who’ve been sent to Catalonia as reinforcements.

They have the numbers to remove Puigdemont, but it would trigger a rejection in the streets. More than 800 people were injured when those officers tried to shut down Sunday’s vote, so there’s a clear risk that the situation could spin out of control.

The Catalan police force adds another element of uncertainty. Sunday also saw a minor scuffle between Spanish and Catalan police, one Catalan officer was arrested for attacking a national police vehicle and tensions between the different forces are running high. If Spain took control of Catalonia, Rajoy would probably need support from the Catalan police to impose and maintain order.

The Catalan independence vote can be seen in the wider context of a condemnation of the severe fiscal austerity handed down by the European Commission and ECB, to countries on the Eurozone’s periphery, in response to the credit crisis. Forcing governments to absorb the bad debts of private institutions, without recourse to a sharply devalued currency, has put great pressure on the populations of the respective countries and Spain’s current political impasse is a real-time example of what that can lead to.

Catalan Independence Drive to Haunt Madrid Whatever Happens Next

This article by Maria Tadeo for Bloomberg may be of interest to subscribers. Here is a section:

Catalonia, which includes Barcelona and accounts for a fifth of Spain’s economy, is attempting to become the first of 17 autonomous regions that already enjoy a measure of self-government to hold a binding plebiscite on independence. It staged a nonbinding ballot three years ago that was backed by about 80 percent of voters, though barely 30 percent of those eligible turned out.

The rebel administration is pressing ahead with the referendum even after Rajoy’s government seized 10 million ballots, deployed thousands of police and arrested more than a dozen Catalan officials.

“This is the most serious constitutional crisis Spain has faced,” said Alejandro Quiroga, professor of Spanish history at the University of Newcastle in the U.K. “The Catalan question could trigger a competition among the other regions to test how far they can go. It’s a very complex matter.”

How much did the discovery of America, and the riches that flowed into Spain as a result, cement the binding together of Castille and Aragon when Isabella and Ferdinand were wed? There is no doubt economic abundance reduces nationalistic tendencies but the opposite is also true.

Trump's Tax Cuts Seen Producing Short Job Growth 'Sugar High'

This article by Lynnley Browning for Bloomberg may be of interest to subscribers. Here is a section:

There is good news for Trump and the Republican Congress: A short-term economic jolt might help make congressional elections next year smoother for them.

In effect, making the deduction temporary would “pull forward” companies’ future purchases and “juice economic activity in the front, during this term leading into re-election,” said Michael Drury, the chief economist of McVean Trading & Investments in Memphis.

Grover Norquist, the president and founder of the conservative group Americans for Tax Reform, says he thinks the tax plan would produce sustained growth. But he acknowledged the issue’s political importance.

“This tax bill, and its growth, is going to be the central piece of legislation that voters will vote on in October and November of 2018,” Norquist said earlier this week.

The Trump administration is going to need to deliver on at least one major success if it is to succeed in sustaining the Republican Party’s electoral success. That will be a central motivation for politicians as they assess the merits of this plan which is still notably skimpy on details. That also suggests a willingness to negotiate on the details so long as the central thesis of lower corporate tax rates and higher tax-free bands remain.

The World Is Creeping Toward De-Dollarization

Thanks to a subscriber for this article by Ronald-Peter Stöferle for the Mises Institute. Here is a section:

A clear signal that something is afoot would be the abolition of the Saudi riyal's peg to the US dollar. As recently as April of this year economist Nasser Saeedi advised Middle Eastern countries to prepare for a “new normal” — and specifically to review the dollar pegs of their currencies: “By 2025 it is clear that the center of global economic geography is very much in Asia. What we’ve been living in over the past two decades is a very big shift in the political, economic, and financial geography.”

While the role of oil-producing countries (and particularly Saudi Arabia) shouldn't be underestimated, at present the driving forces with regard to de-dollarization are primarily Moscow and Beijing. We want to take a closer look at this process.

There exist numerous political statements in this context which leave no room for doubt. The Russians and Chinese are quite open about their views regarding the role of gold in the current phase of the transition. Thus, Russian prime minister Dimitri Medvedev, at the time president of Russia, held a gold coin up to a camera on occasion of the 2008 G8 meeting in Aquila in Italy. Medvedev said that debates over the reserve currency question had become a permanent fixture of the meetings of government leaders.

Almost ten years later, the topic of currencies and gold is on the Sino-Russian agenda again. In March, Russia's central bank opened its first office in Beijing. Russia is preparing to place its first renminbi-denominated government bond. Both sides have intensified efforts in recent years to settle bilateral trade not in US dollars, but in rubles and yuan. Gold is considered important by both countries.

Oil and its derivative products are used in every country in the world so it is logical that the acquiescence of major suppliers to a Dollar standard is a necessary condition of the USA’s international currency hegemony. However, it is not the only consideration.

There were a number of interesting points raised but I believe the most relevant for subscribers’ centre on what he said about shrinking the Fed’s balance sheet, the outlook for the Dollar, commodity markets, the relative attractiveness of emerging markets and his best guess for when to expect the next recession.

Another Look at Why the Return to Capital is Low

Thanks to a subscriber for this highlighting this article by Marc Chandler for Brown Brothers Harriman. Here is a section:

Similarly, a new strategy to deal with the surplus capital, not within our grasp. In the meantime, officials are trying to come up with other ways to absorb the surplus, including changes in the regulatory environment. In some ways, it might be helpful to think about QE itself as an attempt to deal with the surplus capital.

When farmers have a bountiful crop, and the price threatens to fall below the cost of production, governments often invent schemes to buy the crop and warehouse it and let it agricultural produce come to market when at a better (i.e., lucrative) time. In some ways, QE can be understood as a similar strategy: Warehouse the surplus capital. This is not a permanent solution. There is a political push back on the grounds that it blurs monetary and fiscal policy. There is an ideological resistance to the “interference” with market forces. There are economic arguments against the distortion of prices and the mutation of printing signals.

Interest rates are low, not simply because central banks are buying bonds and maintaining large balance sheets by recycling maturing issues. Interest rates are low because there is too much capital. It is a recurring source of the crisis in market economies. We should anticipate that returns to capital will remain low until a new strategy to deal with the surplus is devised and accepted, and the risk is that we are still in denial.

This is an interesting take on the condition we see today in the financial markets and is a topic worthy of consideration because it will influence how high interest rates can rise in the current environment.

Email of the day on maturity extensions

Why does the US not shift its bonds to 20 and 30-year duration, increase inflation to, say, 2% and pay back the money in 20 or 30 years’ effectively free of interest? This would really kick the can down the road and give them many years to sort out the mess. When I asked this of Americans five years ago, they thought it would cause interest rates to spike if the Fed tried to drastically increase the duration. I think the last few years have proved that the duration could be increased without causing panic in the markets.

Thank you for this email and since no one has ever successfully taken trillions of Dollars out circulation before I suspect everyone is asking how this can be done effectively. The Fed went through a maturity extension program between 2011 and 2012 which swapped about 667 billion from short-dated to longer dated securities. Here is a section from the Fed’s 2012 press release on the subject:

Specifically, the Committee intends to purchase Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.

Fed Asset-Shrinking to Start Next Month; Rate Hike Seen in '17

This article by Craig Torres for Bloomberg may be of interest to subscribers. Here is a section:

“The labor market has continued to strengthen” and economic activity “has been rising moderately so far this year,” the Fed statement said. The FOMC repeated language saying “near- term risks to the economic outlook appear roughly balanced.”

The decision to leave the target range for the federal funds rate unchanged and begin the balance-sheet runoff in October was unanimous. The Fed reiterated that interest rates are likely to rise at a “gradual” pace, though updated forecasts indicated that officials see the path as less steep than before.

In their new set of projections, Fed officials estimated three quarter-point rate hikes would be appropriate next year -- the same number they saw in June -- based on the median in the so- called dot plot of interest-rate forecasts.

Crisis Action
The Fed's decision to exit from balance-sheet policies comes a decade after the global financial crisis began to tip the economy into a recession at the end of 2007. The reduction in assets will be slow -- just $10 billion a month to start.

The Fed’s balance sheet has been steady at close to $4.5 trillion since early 2015 when the process of tapering quantitative easing ended. The issue facing the Fed is that they want to continue to raise interest rates, but that is going to have a deleterious effect on the Treasury’s finances as bonds mature and are refinanced at higher rates. The answer they are experimenting with is reducing the size of the balance sheet so there are fewer bonds which need to be refinanced.

It's Not Just Toys R Us. More Credit Weak Spots Emerge

This article by Sid Verma for Bloomberg may be of interest to subscribers. Here is a section:

Money managers are grappling with an uptick in operational and balance-sheet challenges late in the business cycle, with debt-laden Toys ‘R’ Us Inc. the latest retailer to file for bankruptcy this week, catching bond markets off guard. Just two weeks ago, credit-default swaps, which allow traders to hedge against losses, were pricing in a low probability of near-term default at about 10 percent based on contracts expiring in June.

"Companies with the weakest fundamentals often show problems first late in a cycle, and the retail sector has many such examples," said Adam Richmond, Morgan Stanley’s chief credit strategist.

"Investors initially treat those issues as idiosyncratic, and then the problems spread, when credit conditions begin to tighten,” he said. “That is how the late cycle can transition to end of cycle."

These risks are hard to see at the index level, with the Bloomberg Barclays U.S. high-yield benchmark up almost 7 percent this year, led by CCC-rated names. Still, the latter has underperformed the broader market over the past two months, suggesting investors are increasingly compelled to price-in deteriorating fundamentals -- reminiscent of a market in its late winter, according to the U.S. lender.

“You don’t know who’s been swimming naked until the tide goes out” is one of Warren Buffett’s most memorable sayings. There is no doubt that abundant cheap liquidity has aided a considerable number of what might otherwise have been considered marginal businesses to remain solvent. The big question now is how they are going to refinance debt at equally attractive levels when it comes due over the coming years?

Gold in correction mode

Thanks to a subscriber for this report from Commerzbank which may be of interest. Here is a section:

Precious metals: Gold has dropped to a 2½-week low of $1,315 per troy ounce this morning amid increased risk appetite among market participants. Gold in euro terms is trading at only around €1,100 per troy ounce. The Dow Jones Industrial Average and S&P 500 indices in the US had both climbed to new record highs on Friday. The rise in stock markets is continuing in the Asian region today. What is more, bond yields in the US have increased significantly of late, which makes gold less attractive as an alternative investment.

Presumably this is also why Friday saw the second consecutive daily outflow from gold ETFs. Portugal’s credit rating was upgraded on Friday evening by the ratings agency S&P, achieving an investment grade rating again for the first time since January 2012. Ireland was also upgraded, this time by the ratings agency Moody’s. Wednesday could see further volatility on the gold market, as this is when the US Federal Reserve meeting will take place.

If the market’s currently low rate hike expectations increase as a result of the meeting, this is likely to weigh on the gold price. According to the CFTC’s statistics, speculative financial investors further expanded their net long positions in gold in the week to 12 September, putting them at 253,500 contracts now. This was already the ninth weekly increase in a row.
The price rise to a 13-month high of just shy of $1,360 was thus driven largely by speculation. Given that the gold price is now trading considerably lower, positions have presumably been squared in the meantime

We are in a period of synchronised global economic expansion where central banks are only just beginning to turn the corner towards tightening; with the USA’s Federal Reserve in the lead. Commodities no longer share the trending commonality evident at the dawn of the commodity boom in the early 2000s. Industrial resources including palladium are recovering while energy and agricultural prices have been subject to a great deal of volatility.

Pound Sentiment Is Now the Most Bullish in More Than Three Years

This article by Vassilis Karamanis for Bloomberg may be of interest to subscribers. Here is a section:

Currency traders haven’t been this upbeat on the pound in more than three years.

The cost of owning one-month call options on sterling relative to puts reached six basis points, the steepest since February 2014, as the Bank of England said the market is underpricing the prospect of rate increases.

The premium on calls shows the market’s conviction that the currency’s more than 3 percent rally against the dollar this month has legs.

The key question on investors’ minds at the moment is: where does the pound go from here? To some extent, the currency’s fortunes against the dollar will be influenced by what the Federal Reserve does, and in this context next week’s FOMC meeting will take on added significance. Witness also that stronger-than-estimated consumer-price inflation data out of the U.S. on Thursday failed to damp bullish sentiment for the pound.

The Pound has the clearest signs of base formation completion against the Dollar not least because the Dollar has been so weak since early January. It is now breaking up out of a first step above the type-2 base and a clear downward dynamic would be required to question medium-term scope for some additional upside.

Email of the day on the deflationary impact of technology

I have noticed from your recent postings that while you recognize all the great outcomes technology will bring, you also recognize the downside consequences of all the displaced labor. Another effect on labor has been the financialization of our economy. Check out this article (open domain) Thank you for your continued great work!

Thanks for this link may also of interest to subscribers. I found the chart of wages and salaries as a percentage of GDP to be particularly interesting.

Technology is inherently deflationary which means we can do more with less and each of us can easily come up with examples of how innovations have improved different aspects of our lives. However, the rapid pace of innovation in artificial intelligence, robotics and healthcare while representing truly exciting developments for corporations also mean that millions of jobs are going to be under pressure.

Comparing Risk and Opportunity

Thanks to a subscriber for this summary by Byron Wein for Blackstone, from his series of discussions with investors. Here is a section:

There was general agreement that both inflation and productivity were understated. Housing is a big part of the inflation calculation and, for most of the country, housing costs have been rising modestly. The prices of services like healthcare and lifestyle-supporting needs used by everyone, such as haircare and cleaning services, have risen sharply but don’t show up in the numbers. As for productivity, the measurement techniques were developed in the 1950s when the U.S. was more of a manufacturing economy. Now with services and knowledge-based industries so important, the historical measurement approaches, which underestimate the impact of computer software developments, understate productivity improvements. Time spent posting and reading posts on Facebook during working hours, however, detracts from productivity. One technology person pointed out, though, that the video games of today are intensely interactive and represent a learning experience for the kids playing them. This is in sharp contrast to the passive watching of television by previous generations.

We talked a bit about inequality and agreed the problem was likely to become worse because of globalization and technology. One investor was optimistic, however, because of the positive impact machine learning was making in improving the outlook of disadvantaged Americans and educational opportunities in the emerging markets. Another pointed out that 60% of the jobs held in 1980 don’t exist today and still unemployment is down to 4.3%. On-demand services, such as Uber, are creating jobs, but technology displacing workers is a problem throughout the world.

Even though there was an apprehensive mood at the lunches few were buying gold as a safeguard. In spite of the strong performance of the Japanese economy this year and the rise in its stock market, the group remained wary of Japan. There was no clear consensus on why the dollar was weak, but a lack of confidence in the new administration in Washington was clearly a factor in spite of strong U.S. growth and a rising stock market. One of the lunches was decidedly bearish. Overall, a vote on market performance between now and year-end showed that 60% believed it would be higher in spite of the caution expressed in the discussion.

What I spend money on every month is going up in price yet official inflation measures tell me there is little inflation. I took a look at my family’s expenditures on a year over year basis at the weekend. My health insurance went up 30% last year, my children’s tuition increased 10%, my car insurance went up 8%, food was relatively unchanged and gasoline was volatile. Meanwhile my mobile phone service got cheaper.

This could be 'the scariest chart in the financial markets right now'

This is an example of one of the articles I have received from subscribers quoting the same data point. Here is a section:

“As investors go ‘kookoo’ for risk assets, they have pushed (with the help of ECB) the yield of European junk bonds towards that of the U.S. Treasury yield. Honestly… I’m speechless,” Brkan adds.

Another one worried about low yields for European junk bonds is Wolf Street blogger Wolf Richter, who notes they offer around 2.42%, while the U.S. 10-year pays out about 2.24%. And Bank of America Merrill Lynch’s credit strategists are concerned, highlighting the “eye-watering levels that European high-yield has now reached.”

I initially saw a similar article on Monday, assessed the argument and set it aside. However, a number of subscribers have emailed me variations on the story so I thought it might be instructive to highlight why I set it aside in the first place.

Greenspan Sees No Stock Excess, Warns of Bond Market Bubble

This article by Oliver Renick and Liz McCormick for Bloomberg may be of interest to subscribers. Here is a section:

“By any measure, real long-term interest rates are much too low and therefore unsustainable,” the former Federal Reserve chairman, 91, said in an interview. “When they move higher they are likely to move reasonably fast. We are experiencing a bubble, not in stock prices but in bond prices. This is not discounted in the marketplace.”

While the consensus of Wall Street forecasters is still for low rates to persist, Greenspan isn’t alone in warning they will break higher quickly as the era of global central-bank monetary accommodation ends. Deutsche Bank AG’s Binky Chadha says real Treasury yields sit far below where actual growth levels suggest they should be. Tom Porcelli, chief U.S. economist at RBC Capital Markets, says it’s only a matter of time before inflationary pressures hit the bond market.

“The real problem is that when the bond-market bubble collapses, long-term interest rates will rise,” Greenspan said. “We are moving into a different phase of the economy -- to a stagflation not seen since the 1970s. That is not good for asset prices.”

Central bank balance sheets are at levels that were previously unimaginable and nobody knows what the medium to long-term consequences of that are going to be. Generally speaking central banks either tightening too much, or too quickly, is one of the leading causes of crashes, so there is an increased risk of trouble for the simple reason that we are in unchartered monetary territory.

The Great Rotation May Finally Be at Hand

This article by Sid Varma for Bloomberg may be of interest to subscribers. Here is a section:

George Pearce’s, a macro strategist with Bespoke Investment Group LLC, said: “Higher risk-adjusted returns for stocks should draw inflows, and we know from our work that Americans are relatively unexposed to the market.”

Companies have been the main buyer of U.S. equities since the post-crisis low, while households and institutions have divested, according to Credit Suisse. The outperformance of bonds since the financial crisis, risk aversion and regulations unfriendly to equities have helped create a preference for fixed income.

Global bond funds -- which include government and high-yield obligations -- have seen $1.3 trillion of net inflows since 2009, while stocks have taken in less than half of that at $600 billion, according to Jefferies Group LLC, citing EPFR Global data, which reflect holdings among mutual and exchange-traded funds.

In the first half of the year, bond funds took in $204 billion while stocks saw $167 billion of inflows. A $107 billion injection into fixed-income in the second quarter was the highest on record going back to 2002, Jefferies said. This happened despite fears of higher global yields.

The size of the bond market is multiples the size of the equity market. Bonds are held in pension funds because they are supposed to offer stability, yield and some diversification from the perception of higher risk attached to stocks. Right now, the US 10-year Treasury yield is around 1.23% and the S&P500 yields 1.98% which is not a very wide spread.

Dimon Says QE Unwind May Be More Disruptive Than You Think

This article by Cindy Roberts may be of interest to subscribers. Here is a section:

“We’ve never have had QE like this before, we’ve never had unwinding like this before,” Dimon said at a conference in Paris Tuesday. “Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

Central banks led by the U.S. Federal Reserve are preparing to reverse massive asset purchases made after the financial crisis as their economies recover and interest rates rise. The Fed alone has seen its bond portfolio swell to $4.5 trillion, an amount it wants to reduce without roiling longer-term interest rates. Minutes of the Fed’s June 13-14 meeting indicate policy makers want to begin the balance-sheet process this year.

“When that happens of size or substance, it could be a little more disruptive than people think,” Dimon said. “We act like we know exactly how it’s going to happen and we don’t.”

Cumulatively, the Fed, the European Central Bank and the Bank of Japan bulked up their balance sheets to almost $14 trillion. The unwind of such a large amount of assets has the potential to influence a slew of markets, from stocks and bonds to currencies and even real estate.

“That is a very different world you have to operate in, that’s a big change in the tide,” Dimon said. All the main buyers of sovereign debt over the last 10 years -- financial institutions, central banks, foreign exchange managers -- will become net sellers now, he said.

These are common sense statements from one of the most important CEOs in the industry and suggests central banks need to be very careful about how they adjust the status quo. That’s particularly true considering the effect quantitative easing has had on asset price inflation which was by design.

Breakfast with Dave

Thanks to a subscriber for David Rosenberg’s report for Gluskin Sheff dated yesterday. Here is a section:

The Fed seems to have rose-colored glasses on regarding this experiment ahead in terms of even gradually unwinding the balance sheet and the impact on the same financial markets that are deemed at least those around the table (presumably the one with Bloomberg terminal) to be excessively exuberant. And at the same time, the view on the economic outlook seems quite rosy, then again, the central bank has overestimated economic growth consistently for the past seven years. Old habits die hard.

But there are some at the Fed that share our views on many items. Here were a few new wrinkles:
“Contacts at some large firms indicated that they had curtailed their capital spending, in part because of uncertainty about changes in fiscal and other government policies…”

Reports regarding housing construction from District contacts were mixed.”

District contacts reported that automobile sales had slowed recently; some contacts expected sales to slow further, while others believed that sales were leveling out”

So here we have soft capex, soft housing and soft autos. But yet the consensus view is that the economy is doing just fine. A case of cognitive dissonance?

You have Ray Dalio saying, keeping dancing but stay close to the door, regarding the equity market. Jeff Gundlach says the run-up in yields is only beginning. David Rosenberg says deflation is here to stay. The problem for investors is that they all make cogent arguments and it is difficult to divine just where we are and what is likely to happen next. Let’s just stick to the charts.

Email of the day on Japanese Bank funds

Hello Eoin! Thank you for all your hard work for us! You highlighted the Japanese Banks a few Days ago! Is there a Japanese Banks ETF or a closed end Bank fund, that you know of. Best regards. (an FM since 1988).

Thank you for your long support and this question which may also be of interest to other subscribers. There are two Japanese listed ETFs focusing exclusively on Japanese banks but I’m afraid I do not know of any others listed elsewhere whether ETFs or closed-end funds.

The two Japanese ETFs are the Daiwa Topix Bank ETF (1615 JP) and the Nomura Topix Banks ETF (1612 JP).

Fed Officials Divided on When to Begin Balance-Sheet Unwind

This article by Craig Torres for Bloomberg may be of interest to subscribers. Here is a section:

“Several preferred to announce a start to the process within a couple of months,” the minutes of the June 13-14 meeting released on Wednesday in Washington showed. “Some others emphasized that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation.”

U.S. central bankers in June raised the benchmark lending rate for a second time this year to a range of 1 percent to 1.25 percent, while describing monetary policy as “accommodative” in their statement. They reiterated their support for continued gradual rate increases, according to the minutes.

Fed officials updated their balance-sheet policy in the gathering, laying out a path of gradual reductions with caps. The central bank wants to start winding down the $4.5 trillion bond portfolio without roiling longer-term interest rates, while gradually raising the policy rate. The minutes indicated that the committee wants to begin the balance-sheet process this year.

The only example we have of withdrawing liquidity following a bout of quantitative easing is from the ECB between 2012 and 2014 when they took €1 trillion out of circulation. That resulted in deflationary pressures picking up and forced a change of emphasis in Frankfurt which has subsequently seen the size of the balance sheet more than double. Against that background it is hardly surprising there is some disagreement about how to proceed within the Fed and the consensus, as Janet Yellen stated last month, would be to proceed slowly.

We are Witnessing the Development of a 'Perfect Storm'

Thanks to a subscriber for this interview of Bob Rodriguez which may be of interest. Here is a section:

Thus, since 2007, indexing or passive activities have risen from approximately 7% to 9% of total managed assets to almost 40%. As you shift assets from active managers to passive managers, they buy an index. The index is capital weighed, which means more and more money is going into fewer and fewer stocks.

We’ve seen this act before. If you didn’t own the nifty 50 stocks in the early 1970s, you underperformed and, thus, money continued to go into them. If you were a growth stock manager in 1998-1999 and you were not buying “net” stocks, you underperformed and were fired. More and more money went into fewer and fewer stocks. Today you have a similar case with the FANG stocks. More and more money is being deployed into a narrower and narrower area. In each case, this trend did not end well.

When the markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.

Will ETFs contribute to the next major stock market decline? How could they not? They represent a significant proportion both of daily traded volume and act as repositories for substantial inventories of stock. In tandem with the prevalence of automated trading systems we already have evidence of dislocations in the spate of flash crashes we have largely become inured to.

Eoin personal portfolio: bond position closed

Pound Jumps as Carney's Hawkish Tone Sends Gilts Tumbling

This article by John Ainger for Bloomberg may be of interest to subscribers. Here is a section:

The pound soared by the most in two months and U.K. bonds slumped as Bank of England Governor Mark Carney said the Monetary Policy Committee may need to begin removing stimulus.
Sterling climbed against all but one of its major peers as the comments marked a shift in emphasis for the governor, who signaled last week that now was not yet the time to start the tightening process. The yield on two-year gilts touched the highest in more than a year as money markets adjusted to the change in language.

Sterling has borne the brunt of political and economic uncertainty since the Brexit vote, and has been further buffeted in recent weeks by a growing split among policy makers over the future path of rates. The bank’s Financial Policy Committee increased the countercyclical buffer Tuesday, marking the first unwinding of last year’s stimulus package put in place by the bank.

“The headlines appear to be in complete contrast to the Mansion House speech last week, when he said now is not the time for tightening,” said Jane Foley, head of foreign-exchange strategy at Rabobank in London. “There is the possibility that the Bank of England will, over the next few months, fire other shots across the bow really to reduce that downside potential for the pound.”

Central bank communication has a whipsaw feel to it over the last week. The Bank of England first said that it was not ready to remove stimulus and is now saying that an interest rate hike might be closer than we think. Meanwhile Mario Draghi fumbled his communication yesterday when he said the deflationary threat is gone which the market interpreted as a signal the ECB is discussing tapering and officials were back peddling today saying nothing has changed.

Seattle's Painful Lesson on the Road to a $15 Minimum Wage

This article by Megan McArdle may be of interest to subscribers. Here is a section:

And particularly be prepared to rethink very high minimum wages, like those supported by the “Fight for $15” folks. For as the authors note, the first round of hikes had relatively small impacts, while the second round had huge ones, suggesting that the effects may be nonlinear. And that makes sense. Relatively few people in this country make the minimum wage, so a small increase doesn’t make that much difference to most workers, or most employers. But a large jump affects more people, and the wage increases are much bigger for the lowest-paid staffers. If you make $9 an hour, but generate $10.50 in revenue for your boss, a law that raises the wage to $10.45 may cause her to shrug and decide it’s easier to keep you on as long as she’s making something. But a wage that forces her to pay you far more than you bring in…. Continuing to employ you would just be bad business.

It’s worth noting that Card and Krueger’s famous study involved an increase in the minimum wage from $4.25 an hour to $5.05. That was a significant increase -- about 18 percent. But Seattle’s minimum wage has already increased by 37 percent, and it still has roughly another 20 percent to go.

At some level, we all intuitively understood that this was true. If the minimum wage increases by a penny an hour, probably even most rock-ribbed conservatives would not predict mass firings. On the other hand, if the wage was arbitrarily set to $100 an hour, even ardent labor activists would presumably expect widespread unemployment to follow. You can’t flat-out say “minimum wages don’t increase unemployment,” because the size of the increase, and the level of the resulting wage, obviously matter at some margin.

As this article highlights, very few people in the USA earn the minimum wage. However about a third of the population earns less than $35,000 a year. $15 an hour for a 40-hour, 52 weeks a year comes out to $30,200. Therefore by raising the minimum wage to $15 either those earning slightly more than the current minimum wage will demand more for their work or they will be equated with first time job applicants at fast food restaurants.

High Yield Credit Handbook

Thanks to a subscriber for this report from Goldman Sachs which may be of interest to subscribers. Here is a section:

HY total returns of 4.5% YTD have surpassed our YE target: In what has been a continuation of a strong 2016, total returns surpassed our Credit Strategists’ full year target of 3% by the end of the first quarter. We attribute much of the surprise to the US Treasury move lower, but also point out that current HY spreads of 390bp are ~50bp tighter YTD.

And US Treasury rates are … lower. We entered 2017 with the expectation that three rate hikes could help drive the 10yr UST 50bp higher, to 3.00% (GS Economics view). At mid-year, UST rates have instead declined 35bp, to 2.15% (see Exhibit 1) and our Economics team recently lowered their YE2017 forecast to 2.75% (from 3.00%). To be clear, the revised target still implies a 60bp move higher which could drive a headwind of 2.85% for the HY market (based on an average market duration of 4.76 years).

Spreads are tighter despite over $4.9bn of YTD HY outflows: With the rally in global risk assets, high yield market spreads have tightened ~50bp to 390bp, or inside the 20th percentile relative to the last 30 years. This spread move is even more surprising given it has unfolded in the face of $4.9bn of cumulative HY net outflows YTD. In fact, the HY market has experienced net cumulative outflows this late into the year only once in the last 10 years (see Exhibit 2).

Robust primary volumes continue: HY new issue activity surpassed $300bn in each of 2012, 2013, and 2014, and breached the $250bn mark for 2015. Despite dipping in 2016 (not surprising given the weak macro backdrop in 1Q2016) to $227bn, HY issuance appears poised to make a rebound this year with volumes trending up 6% yoy.

US policy is evolving and remains a key variable: The ramp in soft economic data (see Exhibit 3) suggests the outcome from last year’s election has positively impacted economic sentiment. However, hard economic data (like GDP), as measured by the GS Economics team has yet to inflect. For risk sentiment to remain elevated, we expect investors to be looking to the potential for the hard data to improve and growth to accelerate.

Disruption has been dangerous… what’s the next Rental/Retail/RLEC story? As the HY market has steadily marched higher, not all credits have participated. The market has been particularly unforgiving to stories where secular disruption has emerged. The rental, retail and RLEC sectors are prime examples here (see Exhibit 4) but we also have concerns over legacy software providers, the auto sector, the hospital facilities space and certain parts of media (see p. 4).

The bond market has been the surprise outperformer this year particularly following the accelerated pullback following the election. The broader question is whether that is likely to continue if the Fed does indeed follow through on shrinking its balance sheet.

The Old Are Eating the Young

This article by Satyajit Das for Bloomberg may be of interest to subscribers. Here is a section:

This growing burden on future generations can be measured. Rising dependency ratios -- or the number of retirees per employed worker -- provide one useful metric. In 1970, in the U.S., there were 5.3 workers for every retired person. By 2010 this had fallen to 4.5, and it’s expected to decline to 2.6 by 2050. In Germany, the number of workers per retiree will decrease to 1.6 in 2050, down from 4.1 in 1970. In Japan, the oldest society to have ever existed, the ratio will decrease to 1.2 in 2050, from 8.5 in 1970. Even as spending commitments grow, in other words, there will be fewer and fewer productive adults around to fund them.

Budgetary analysis presents a similarly dire outlook. In a 2010 research paper, entitled “Ask Not Whether Governments Will Default, But How,” Arnaud Mares of Morgan Stanley analyzed national solvency, or the difference between actual and potential government revenue, on one hand, and existing debt levels and future commitments on the other. The study found that by this measure the net worth of the U.S. was negative 800 percent of its GDP; that is, its future tax revenue was less than committed obligations by an amount equivalent to eight times the value of all goods and services America produces in a year. The net worth of European countries ranged from about negative 250 percent (Italy) to negative 1,800 percent (Greece). For Germany, France and the U.K., the approximate figures were negative 500 percent, negative 600 percent and negative 1,000 percent of GDP. In effect, these states have mortgaged themselves beyond their capacity to easily repay.

Plato’s Republic, probably his best known work, lays out five stages of political development. Democracy, as Plato defines it, does not equate with our constitutional democracy but there are definitely parallels. Our constitutions seek to protect the needs of the few from the appetites of the many. More importantly elections ensure we do not end up with tyrants while separation of powers and an independent judiciary keep a lid on despotic aspirations.

Fed Outlines Balance Sheet Unwind With $10b Reinvestment Cap

This article by Alexandra Harris for Bloomberg may be of interest to subscribers. Here it is in full:

Federal Reserve said it intends to initially cap its Treasury reinvestments at $6b/month and MBS at $4b/month and increase both at three-month intervals over a 12-month period, according to statement.

Fed said it will begin balance sheet normalization this year if the economy evolves as the central bank anticipates

Cap on UST reinvestments will increase by $6b increments until reaching $30b/month; MBS cap will increase by $4b increments until it reaches $20b/month

FOMC anticipates caps will remain in place once they reach their maximums so the Fed’s holdings will “continue to decline in a gradual and predictable manner” until the committee decides that the Fed is “holding no more securities than necessary” to implement monetary policy

FOMC anticipates level of reserves will decrease to a level “appreciably below that seen in recent years but larger than before the financial crisis”

While the fed funds rate will remain primary monetary policy tool, FOMC said it will be prepared to resume reinvestments “if a material deterioration in the economic outlook” were to warrant a sizable reduction in rates.

A great deal of debt needs to be refinanced between 2018 and 2021 so slow pace of balance sheet run off is positive news for the treasury market because it ensures the Fed will still be reinvesting at least some of its expiring debt in new issues.

QE created bank deposits and balance-sheet unwind will eliminate them; while “massive 2003-style bank sales” are not predicted, the market “has become extremely sensitive to flows,” and risk of outsized price action is higher during summer months

Main issue isn’t a funding shortfall, but “how modeling of deposits changes” and when; deposits modeled on recent data show extremely long average life; shortening the expected life of a deposit puts pressure on banks to shorten their assets

Bank buying of shorter-duration assets should lead to “outperformance of 15yrs and CMOs and a steeper curve”

RBC expects Fed likely to announce balance-sheet unwind in September, begin in October, with initial caps of $15b for USTs, $10b for MBS; they expect caps to rise by $15b and $10b every quarter and eventually be eliminated

When the biggest buyer in a market stops investing and starts divesting of its holdings it represents a sea change in the interaction between supply and demand. If high prices are to be sustained the remaining buyers need to increase their purchases to compensate for the absence of a once stalwart buyer.

How Long Can the Fed Keep the Boom Going?

Thanks to a subscriber for this article by Thorsten Polleit for the Mises Institute. Here is a section:

To keep the boom going, the central bank must keep interest rates below their natural levels. It cannot raise them back to “normal.” First and foremost, higher interest rates would make the boom collapse. The credit market would collapse, stock and housing prices would tumble, and the financial system and the economy as a whole would go into a tailspin.

One may ask: Why is the Fed then raising rates then? Perhaps the Fed’s decision-makers think that the US economy has overcome the latest crisis and higher interest rates are economically justified. Others might wish to tighten policy for getting the short-term inflation adjusted interest rate out of negative territory.

Be it as it may, the disconcerting truth is this: Fed rate hikes will close the gap between the natural interest rate and the actual interest rate level. This, in turn, amounts to putting a brake on the boom, bringing it closer to bust. It is impossible to know with exactitude at what interest rate level the US economy would fall over the cliff.

One thing is fairly certain, though: The US economy, and with it the world economy, is caught between a rock and a hard place. Maybe the Fed’s current rate hiking spree will bring about the bust. Or the Fed refrains from raising rates further and keeps the boom going a little bit longer.

We'll Live to 100 How Can We Afford It?

Thanks to a subscriber for this report from the World Economic Forum. Here is a section:

In Japan, which has one of the world’s most rapidly ageing populations, retirement can begin at 60. This could result in a retirement of over 45 years for those who will live to the current life expectancy of 1071 (see Figure 2). What is the impact of a population that will spend 20%-25% more time in retirement than they did in the workforce? How do we rethink our retirement systems that were designed to support a retirement of 10-15 years to prepare for this seismic shift?

One obvious implication of living longer is that we are going to have to spend longer working. The expectation that retirement will start early- to mid-60s is likely to be a thing of the past, or a privilege of the very wealthy.

Absent any change to retirement ages, or expected birth rates, the global dependency ratio (the ratio of those in the workforce to those in retirement) will plummet from 8:1 today to 4:1 by 2050. The global economy simply can't bear this burden. Inevitably retirement ages will rise, but by how much and how quickly demands urgent consideration from policy-makers.

Given the rise in longevity and the declining dependency ratio, policy-makers must immediately consider how to foster a functioning labour market for older workers to extend working careers as much as possible. Employers also have a key role to play in helping workers reskill and adapt their work styles to support a longer working career.

This paper focuses on the sustainability and affordability of our current retirement systems. To protect against poverty in old age, we believe that retirement systems should be designed to provide a level playing field and equal opportunity for all individuals. A well-designed system needs to be affordable for today’s workers and sustainable for future generations to ensure that all financial promises are met.

Healthy pension systems contribute positively towards creating a stable and prosperous economy. Ensuring that the public has confidence in the system, and that promised benefits will be met, allows individuals to continue to consume and spend through their working and retired years. If this hard-earned confidence is lost, there is a significant risk that retirees will moderate their spending habits and consumption patterns. Such moderation would have a negative impact on the overall economy, particularly in countries where the size of the retired population continues to grow.

Action is needed to realign our existing systems with the challenges of an ageing population. Those who take proactive steps will be better equipped in the years ahead.

I’m 40 so according to this report I have a 50% chance of living to 94. The Chart Seminar is in its 48th year in 2017 so you never know I might manage to get it to the century because we are all going to be working a lot longer. It’s a good thing I’m doing something I enjoy and perhaps that is the best advice. You are going to be working for an awfully long time so be prepared to change jobs, adapt and enjoy what you do.

Minutes of the Federal Open Market Committee

This transcript may be of interest to subscriber. Here is a section on how the balance sheet will be run down:

Participants continued their discussion of issues related to potential changes to the Committee's policy of reinvesting principal payments from securities held in the SOMA. The staff provided a briefing that summarized a possible operational approach to reducing the System's securities holdings in a gradual and predictable manner. Under the proposed approach, the Committee would announce a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month. As the caps increased, reinvestments would decline, and the monthly reductions in the Federal Reserve's securities holdings would become larger. The caps would initially be set at low levels and then be raised every three months, over a set period of time, to their fully phased-in levels. The final values of the caps would then be maintained until the size of the balance sheet was normalized.

Nearly all policymakers expressed a favorable view of this general approach. Policymakers noted that preannouncing a schedule of gradually increasing caps to limit the amounts of securities that could run off in any given month was consistent with the Committee's intention to reduce the Federal Reserve's securities holdings in a gradual and predictable manner as stated in the Committee's Policy Normalization Principles and Plans. Limiting the magnitude of the monthly reductions in the Federal Reserve's securities holdings on an ongoing basis could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates. The approach would also likely be fairly straightforward to communicate. Moreover, under this approach, the process of reducing the Federal Reserve's securities holdings, once begun, could likely proceed without a need for the Committee to make adjustments as long as there was no material deterioration in the economic outlook.

Over $4 trillion is still a lot of money, even in the bond markets and how the Fed succeeds in shrinking that number is going to have a significant effect on both the markets and the economy. The ECB embarked on a similar policy between 2012 and 2014; taking €1 billion off its balance sheet so we have a template for what effect that might have on other asset classes.

Email of the day on the yield curve spread and Plato:

I tried to find in the chart library the last chart you should on Friday's Video. That is the difference between the US 10 & 2 year. This Friday's long term outlook was different but I liked it; even got myself a copy of Plato to read

Thank you for a question which may be of interest to subscribers. The yield curve spread is the difference between the 10-year and 2-year Treasury yield. I created this video to discuss both how to create the chart and save it as a preset template for when you want to find it later.

Kuroda Confident Can Raise Wages, Prices "Significantly"

This note by Chua Baizhen Bloomberg may be of interest to subscribers. Here it is in full:

“The mindset is still quite cautious about inflation expectations, but I’m quite sure that with continuous accommodative monetary policy, supported by fiscal policy, we’d be able to eventually raise wages and prices significantly,”

Since its bubble burst in the late 1980s Japan has been attempting to combat deflation and despite its best efforts failed. The big question is whether this was because they were not aggressive enough early on in forcing the banking sector to write down large bad loan books, or was it because their bust occurred in one of the greatest disinflationary periods in modern history and no matter what they did they could not have fomented inflation? I suspect the answer lies somewhere in between.

Fed Sticks to Gradual Rate-Hike Approach Despite Slowdown

This article by Jeanna Smialek and Christopher Condon may be of interest to subscribers. Here is a section:

The widely expected decision contained no concrete commitment to the timing of the next rate increase. Even so, investors increased bets on a move in June after absorbing the Fed’s sanguine assessment of the outlook and its encouraging observations on inflation, following data showing first-quarter economic growth of 0.7 percent and monthly price declines in March.

“Nothing in the statement today, which was voted unanimously by the FOMC, leads me to believe that the Fed is even close to changing its mind on rates,” Roberto Perli, a partner at Cornerstone Macro LLC in Washington, wrote in a note to clients. “Base case is for a couple more rate hikes this year -- probably in June and September -- and for the beginning of balance sheet shrinkage in December.”

3-month Treasury bills are beginning to price in a rate hike in June but the rate is still only 86 basis points while the Fed Funds Target rate is 75 to 100 basis points. That highlights just how reluctant bonds traders have been to give credence to the Fed’s estimates of how often and by how much they are willing to raise interest rates.

Fed May Finally Be Ready to Change Course

This article by Mohamed A. El-Erian for Bloomberg may be of interest to subscribers. Here is a section:

Nevertheless, this will be an interesting test of the view, which I and some others have espoused, that the Fed is in the process of shifting operating regimes -- from following markets to being more willing to lead them.

Last week’s disappointing reading of 0.7 percent gross domestic product growth for the first quarter, the lowest in three years, added to other data releases (such as retail sales, inflation and autos) suggesting that the U.S. economy -- and consumption in particular -- is going through a softer economic patch. In previous years, this would have provided the Fed with the excuse to soften its policy signals, assuring markets that monetary policies will remain ultra-stimulative and minimizing the risk of financial asset volatility. Indeed, these are the signals that the European Central Bank reiterated last week when its governing council met. And the ECB did so despite official recognition that, in the case of the euro zone, economic conditions have improved and forward downside risk is lower.

The Fed’s inclination to repeat past practices is countered by three considerations.

* An element of the recent data weakness is likely to be both temporary and reversible.

* The Trump administration has reiterated its intention to pursue a large tax cut that, if approved by Congress (a big if), would most likely lead to a considerably wider budget deficit, at least in the short-run until economic growth and budgetary receipts pick up (especially given the lack of large revenue measures).

* Though even harder to quantify, the Fed is not indifferent to the collateral damage and unintended consequences of prolonged reliance on unconventional monetary policies.

I believe the bond market is exhibiting what I term a “boy who cried wolf” mentality. After so many warnings and almost a decade where the Fed’s inflation target was wide of the mark on consecutive years there is no appetite for pricing in rate hikes until they are deemed to be imminent. I agree with El Erian, the flow of stimulative rescue funds has a conditioning effect on those benefitting from them. There is no credible belief that the Greenspan, Bernanke and now Yellen puts will be withdrawn.

Two Frances Collide in Battle to Shape Europe's Future

This article by John Follain for Bloomberg may be of interest to subscribers. Here is a section:

Tergnier may be Macron’s toughest sell.

The town, with a population of 13,000, used to vote Communist and then Socialist. It turned to the National Front as its sprawling rail freight station — once one of France’s biggest — shed hundreds of jobs. Steelworks, a sugar-manufacturing plant and other firms closed down or moved elsewhere leaving the jobless rate at 15 percent. The national average is 10 percent. Thirty-six percent of voters backed Le Pen last month, among her highest votes in the country.

“Globalization is bad for Tergnier,” said mayor Christian Crohem, 67, who heads a mainly leftist coalition. “We’ve brought more countries into the EU and we’ve allowed businesses to move around, so we’re up against workers from abroad who don’t play by the same rules, it’s unfair competition.”

He tells the story of a 70-year-old woman who came to see him recently because she didn’t have enough money to feed herself. Sitting in his office, she cried with shame as she asked him for a handout to buy food.

“That kind of thing really gets to you,” he says. “People here feel abandoned, and so do we, the officials they elect.”

In a country like France, which prides itself on its social infrastructure, this kind of story is all the more troubling. Fiscal austerity over much of the last decade has laid bare the hollowing out of rural and legacy manufacturing centres right across the developed world. We are talking about France right now because the election is on Sunday but this is a broad issue which has contributed to populism in a number of countries and there is little evidence of sincere efforts to curb it.

The Global Investment Outlook

Thanks to a subscriber for this report from RBC GAM which may be of interest. Here is a section on bond yields:

The arguments for higher bond yields
The global economy is experiencing a cyclical recovery regardless of the political noise, and its performance should remain the key driver of fixed-income markets over the next 12 months. U.S. data releases have been strong and the employment picture continues to improve, leading many investors to prepare their portfolios for reflation. We believe that Trump’s loosening of financial regulations should re-ignite the animal spirits that went missing after the 2008 financial crisis, creating self-sustaining economic growth. Corporate America will likely invest and hire more, pushing up the cost of capital and inflation.

Aiding this momentum will be an administration stocked with business-minded department heads and White House advisors. Trump has appointed Steve Mnuchin, a former Goldman Sachs executive, as Treasury secretary and billionaire investor Wilbur Ross to head the Commerce Department. Gary Cohn, the recently departed Goldman Sachs president, is Trump’s top economic counsellor. These appointments help to validate the optimism towards streamlining regulations and promoting business investment.

A tight labour market is another source of economic optimism and will foster inflationary pressures as higher wages embolden consumers to spend more. A higher-inflation, faster-growth environment would be a departure from the slow growth mindset that has prevailed since 2012.

Assuming that the government spending materializes as advertised and stokes economic growth, we would expect yields to be pulled higher by competition for capital between Treasury bonds and businesses and individuals seeking loans. Here’s why: capital must be financed either from abroad and/or with domestic savings, and administration proposals aimed at reducing imports would increase the importance of domestic savings as a source of capital. Domestic private savers as a group tend to demand higher compensation for loans than foreign entities, potentially leading to higher rates as growth quickens.

The voter apathy that helped Donald Trump win is about to hit France

This article from quartz may be of interest to subscribers. Here is a section:

The paralysis has no quick fix. Last night (April 4), in an effort to lift spirits, France’s presidential debate organizers decided to trot out all 11 eligible candidates for the second televised debate, rather than just the top five. The barrage of small candidates on stage left each with “no room to develop an idea,” and voters no time “to exercise their judgment,” one critic (link in French) argued. “Does this really help the undecided to form an opinion?” another asked (link in French).
All the better for France’s far-right wing. Voter turnout in France (80% in 2012) has long upstaged that of neighboring Germany (71%), the UK (66%) and Switzerland (47%). But as that number drops in France’s multi-round system, the odds of a far-right win creep up.

That’s because fervent support for Le Pen in the first round will likely carry over to votes for her in the second. But candidates with more tepid support, including centrist Emmanuel Macron, conservative François Fillon, and socialist Benoît Hamon, may suffer if non-Le Pen voters abstain (paywall) in the second round. Right now, Le Pen and Macron are neck-and-neck in French polls for the first round.

The predicament was similar in 2002, when candidate Jacques Chirac’s famous slogan (link in French) “Vote for the Crook, not the Fascist” helped him secure a landslide victory against Le Pen’s father, Jean-Marie Le Pen, in the second round. This time, voters may have had their fill of crooks and fascists both.

Last night my 11-year old asked me what does ennui mean? My French classes from secondary school came roaring back with Mrs. O’Donoghue joking that ennui was roughly translated into boredom but the reaction of the class provided a much better definition than any she could come up with. Here is what Google comes up with “mid 18th century: French, from Latin mihi in odio est ‘it is hateful to me.’ and “a feeling of listlessness and dissatisfaction arising from a lack of occupation or excitement.” Ennui is a problem for entrenched politicians when they face a strident minority willing to vote.

Thank you for this email which raises important points worth covering with regard to Japan’s primary stock market indices.

The Topix is also known as the Tokyo Stock Price Index. It is a free-float adjusted market capitalization-weighted index and comprised of all 1997 shares in the 1st Section of the Tokyo Stock Exchange.

Here is where some of the idiosyncrasies of the system begin. The 1st Section is supposed to comprise all of the large companies and the 2nd Section holds whatever is left. However, at least 80 of the 567 companies in the 2nd Section have larger market caps than the smallest company in the Topix which highlights the fact that the weightings are not actively managed.

Euro-Pound Hedging Costs Rise on Brexit Trigger, French Election

This article by Vassilis Karamanis for Bloomberg may be of interest to subscribers. Here is a section:

The premium on one-month options over the rate of actual market swings remains near a 10-week high set on Tuesday. It may increase further should Brexit-related negativity be less than feared in the near term, which would reduce realized volatility, and also as the implied rate should rise on capturing the second round of the French elections due May 7.

Realized volatility could find support as the euro-pound pair’s prospects look increasingly bearish on charts, with current market positioning significantly skewed toward sterling declines. Leveraged net short positions in the pound this month are at the highest level since November.

Not all investors have given up on the pound, with the British economy performing better than expected. BlackRock Inc., which reduced some of its exposure to sterling ahead of the triggering of Article 50, has said it is still marginally long as an expected slowdown of the U.K. hasn’t materialized.

With the latest reports suggesting that the European Central Bank isn’t anywhere close to reducing economic stimulus, a short-squeeze on the pound could materialize.

Now that Article 50 of the Nice Treaty has been triggered there are at least three big questions outstanding with regard to the Pound and the Euro.

How willing is the Bank of England to run hot on inflation with the economy at full employment and economic growth continuing to surprise on the upside? 1-year notes yields pulled back today suggesting investors are less inclined to think an interest rate hike is anywhere on the horizon.

Six Impossible Things Before Breakfast

Thanks to a subscriber for this report by James Montier for GMO which may be of interest. Here is a section:

It appears that asset markets are priced as if secular stagnation were a certainty. Certainty is a particularly dangerous assumption when it comes to investing. As Voltaire stated, “Doubt is not a pleasant condition, but certainty is absurd.”

In order to believe that asset market pricing makes sense, I think you need to hold any number of “impossible” (by which I mean at best improbable, and at worst truly impossible) things to be true. This is certainly a different sort of experience from the bubble manias that Ben mentioned in the opening quotation, which are parsimoniously captured by Jeremy’s definition of bubbles – “excellent fundamentals, irrationally extrapolated.” This isn’t a mania in that sense. We aren’t seeing the insane behaviour that we saw during episodes like the Japanese land and equity bubble of the late 1980s, or the TMT bubble of the late 90s, at least not at the micro level. However, investors shouldn’t forget that the S&P 500 currently stands at a Shiller P/E of just over 28x – the third highest in history (see Exhibit 17).

The only two times that level was surpassed occurred in 1929 and in the run-up to the TMT bubble. Strangely enough, we aren’t hearing many exhortations to buy equities because it is just like 1929 or 1999. Today’s “believers” are more “sophisticated” than the “simple-minded maniacs” who drove some of the other well-known bubbles of history. But it would be foolish to conflate sophistication with correctness. Current arguments as to why this time is different are cloaked in the economics of secular stagnation and standard finance work horses like the equity risk premium model. Whilst these may lend a veneer of respectability to those dangerous words, taking arguments at face value without considering the evidence seems to me, at least, to be a common link with previous bubbles.

I find myself agreeing with a great deal of what James Montier is arguing. I believe that it does not make sense to take a secular trend which is obviously at a highly developed stage and extrapolate it into infinity. That is just not how markets work. Yet that is exactly what we see in the bond markets.

Citigroup Canary in the Coal Mine

Thanks to a subscriber for this article by Christopher Whalen for theinstitutionalriskanalyst.com which may be of interest. Here is a section:

Citi’s equally large credit card book – in nominal terms the most profitable part of the business – has a gross spread of almost 1,100bp, but also reported over 300bp in defaults in 2016. Still, with a 800bp net margin before SG&A, credit cards are Citi’s best business. Indeed, Citi’s payment processing and credit card business are the crown jewels of the franchise. If there were some way to sell the rest of the Citi operations, the payments processing and credit card business could be worth a multiple of Citi’s current equity market valuation.

The trouble with Citi and many other US banks is that their business are dominated by consumer credit and real estate exposures, with little in the way of pure C&I loans. When you look at most US banks, the vast majority of the exposures are related to real estate, directly or indirectly. Thus when the Fed manipulates asset prices in a desperate effort to fuel economic growth, they create future credit problems for banks. As our friend Alex Pollock of R Street Institute wrote in American Banker last year:

“[T]he biggest banking change during the last 60 years is… the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.”

So whether a bank calls the exposure C&I or commercial real estate, at the end of the day most of the loans on the books of US banks have a large degree of correlation to the US real estate market. And thanks to Janet Yellen and the folks at the FOMC, the US market is now poised for a substantial credit correction as inflated prices for commercial real estate and related C&I exposures come back into alignment with the underlying economics of the properties. Net charge offs for the $1.9 trillion in C&I loans held by all US banks reached 0.5% at the end of 2016, the highest rate since 2012.

Commercial real estate has been directly influenced by the extraordinary monetary policies employed by the Fed and other central banks. I don’t think it is an exaggeration to conclude that rising rents have been a contributing factor in the migration of businesses online and the denuding of the high street and malls of active businesses.

Thank you for this article which may be of interest to subscribers. I too think of the declining velocity of money as a headwind to inflationary pressures getting out of control. However this image of what they consider low interest rates, as below 4.5% is an average level over the last century rather than what might be considered low.

Italexit is not a solution for Italy's problems

Thanks to a subscriber for this article by Lorenzo Codogno and Giampaolo Galli which may be of interest. Here is a section from the conclusion:

The euro is irrevocable. It was designed as Hotel California: “you can check out any time you like, but you can never leave!” However, we know that it would be wrong to take it for granted. Italexit could still happen as the unwilling and messy result of an unbearable deterioration in public finances and economic performance, combined with misguided political will and financial market turmoil. It would be a huge mistake. Much better, and less costly, would be to address the underlying problems, allowing Italy to survive and thrive within the euro by enhancing potential growth and economic resilience.

It would be wrong to conclude that Italexit, or exit from the monetary union by any other Member State, is going to be an easy process that can be evaluated with a straight cost-benefit analysis and smoothly managed in an orderly way. While Roger Bootle, one of the advocates of the return to national currencies, came to somewhat different conclusions, he acknowledged that the exit merely being the reverse of the construction process does not make it easy: “it would be the equivalent of unscrambling an omelette”.

In the case of Italexit, redenomination and default would become very likely and would cause a number of side effects and negative spillovers into the economy. Exit without redenomination would lead the debt-to-GDP ratio to reach 190%, assuming 30% devaluation, making default even more likely. Hence, Italexit would not address the issues its proponents claim it would address, while producing significant financial instability. Just mentioning it as a viable solution as part of a political platform would imply risks of making it a self-fulfilling prophecy. The economic, social, and political consequences would be enormous and last for a number of years.

It has been my view for some time that the sustainability of the Eurozone is predicated on the assumption previously sovereign populations will accept any set of policies imposed by the European Commission.

The Eurozone’s sovereign debt crisis arose because private sector loans made by banks in ‘creditor’ countries were at risk of being defaulted upon which would have caused a financial catastrophe for their home nations. The solution was to insist private sector debts be absorbed by the governments of the countries in which they were taken, with the result that sovereign debt-to-GDP ratios exploded. Massive fiscal austerity was imposed on the populations of peripheral countries which contributed to lower standards of living and deflation.

Deviations From Covered Interest Rate Parity

I found this report by Wenxin Du, Alexander Tepper and Adrien Verdelhan for the National Bureau of Economic Research to be fascinating and commend it to subscribers. Here is a section:

In this paper, we examine the persistent and systematic failures of the CIP condition in the post crisis period. After formally establishing CIP arbitrage opportunities based on repo rates and KfW bonds, we argue that these arbitrage opportunities can be rationalized by the interaction between costly financial intermediation and international imbalances in funding supply and investment demand across currencies. Consistent with this two-factor hypothesis, we report four empirical characteristics of the CIP deviations. First, CIP deviations increase at the quarter ends post crisis, especially for contracts that appear in banks’ balance sheets. Second, proxies for the banks’ balance sheet costs account for two-thirds of the CIP deviations. Third, CIP deviations co-move with other near-risk-free fixed income spreads. Fourth, CIP deviations are highly correlated with nominal interest rates in the cross section and time series.

Looking beyond our paper, we expect a large literature to investigate further the CIP deviations. The deviations occur in one of the largest and most liquid markets in the world after the crisis in the absence of financial distress, suggesting that other arbitrage opportunities exist elsewhere. While trading in exchange rate derivatives is a zero-sum game, the CIP deviations may have large welfare implications because of the implied deadweight cost borne by firms seeking to hedge their cash flows. Furthermore, the existence of CIP deviation introduces wedges between the interest rates in the cash and swap markets, which affects the external transmission of monetary policy. The welfare cost of the CIP deviation is behind the scope of this paper; it would necessitate a general equilibrium model. Yet, even without such model, the CIP condition is a clean laboratory to test the impact of financial frictions in a very general framework. In this spirit, we present the first international evidence on the causal impact of recent banking regulation on asset prices. We expect more research in this direction in the future.

A link to the full report is posted in the Subscriber's Area. When aberrations appear in what is by definition a zero-sum game it is certainly a topic worthy of further study. This is a subject likely to be of particular interest to large institutional traders where a move of 10s of basis points can be multiplied by weight of money and leverage.

Markets on the cusp ...?

Thanks to a subscriber for this report by James W. Paulsen for Wells Fargo may be of interest to subscribers. Here is a section

Trends matter, for among other reasons, because they impact the impressions, expectations and actions of policy officials, investors, consumers and businesses. For this reason, we think investors should be aware of just how many financial market trends are on the cusp this year threatening to breach significant milestones.

Undoubtedly, not all of the trends we highlighted will actually break new ground this year and perhaps none will reach levels that draw much investor focus. However, in 2017, the following list of financial market trends are worth monitoring because they are “on the cusp”…

1. Evidence of inflation is broadening and inflation expectations embedded in the 10-year Treasury TIP bond is only about 0.5% below the highest level in at least 20 years.

2. Three major themes are on the cusp in the U.S. stock market. First, is the recent breach of a two-year old trading range in the S&P 500 Index to a new recovery high possibly suggesting a third leg in this bull market? Second, the relative total return performance of conservative investments is nearing its lowest level of the entire recovery. And finally, the relative performance of small cap stocks is within 10% of rising to a new all-time record high relative to large cap stocks.

3. Bond investors face several important trends on the cusp including the potential end of a 30-year bond bull, a flatter Treasury yield curve and investment grade yield spreads about to reach new narrows for the recovery.

4. The U.S. dollar is in a two-year old trading range which, with a break, will settle whether this is just a pause in an ongoing dollar bull market or the start of a fresh dollar bear market.

5. In the commodity markets, crude oil is on the cusp of breaking out of a two-year old trading range above $60 and industrial commodity prices are within 10% of rising to a new six-year high.

So far, this year has been dominated by political news and what it means for future economic and regulatory policies. Perhaps, however, in a year with so much on the cusp, investor mindsets will eventually become more impacted by financial market trends breaking outside old recovery trading ranges?

I find the choice of words “on the cusp” to be very interesting because it represents a point of view which is outside. It suggests an investor is out of the market and potentially on the cusp of investing again.

Perhaps that’s not overly surprising. The main stock market indices spent almost two years ranging and endured some scary pullbacks during that time. Bonds have sold off aggressively in the last few months which would have prompted at least some investors to raise cash. Commodities prices are rallying of off very depressed levels but with since they are already a year into an advance there are logical questions being asked by those on the side lines centring on whether they are already too late.

Where is the Dollar weakest?

For all the talk of a strong Dollar the only currency that is weaker than it this year is the Turkish Lira and even that is looking very oversold at present following an accelerated decline to test the TRY4 area.

France's Neighbors Sound Alarm Over Election 'Catastrophe' Risk

This article by Esteban Duarte and Patrick Donahue for Bloomberg contains a useful calendar of political events for 2017 and may be of interest to subscribers. Here is a section:

Polls suggest that National Front leader Marine Le Pen will make it to France’s run-off vote on May 7, giving her a shot at claiming the presidency on anti-euro, EU-skeptic ticket. She shared a stage last weekend with Frauke Petry of Alternative for Germany and Geert Wilders, whose anti-Islam platform has helped propel his Freedom Party to within reach of winning the March 15 Dutch election.

Europe’s anti-establishment forces are drawing inspiration from Donald Trump’s surprise elevation to the U.S. presidency and unexpected victory of Brexit supporters in last year’s referendum. Another common strand is an anti-immigration stance that has flourished during the worst refugee crisis since World War II, with more than one million people fleeing war and oppression in Syria, Afghanistan and elsewhere having sought asylum in Germany alone.

Gabriel, who is poised to become German foreign minister in a cabinet reshuffle allied to the Sept. 24 election, pointed to France’s two-round ballot as the key moment that will shape Europe’s destiny. While no recent poll has shown Le Pen coming close to winning the second round, Brexit and Trump’s victory have made political analysts and investors reluctant to rule anything out.

“If Europe’s enemies, after Brexit last year, manage once again in France or in the Netherlands to be successful, then the threat to us is the collapse of the greatest civilization project of the 20th century, the European Union,” Gabriel said in a speech to lower-house lawmakers in Berlin on Thursday.

No one has much faith in polls anymore because people lie about their intentions and those that respond to polls are often not representative of the swing voters that shape results. Lurches to the right in the UK and USA represent dissatisfaction with the status quo. France’s generous social programs have helped nullify populist uprisings until now, but an unemployment rate stuck at 10.2% and youth unemployment of 24% are intransigent problems that the current political apparatus does not appear to have a solution for.

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L.K. 27 July 2016

I have been a subscriber since the 70's.
I have grown with your service and have no hesitation in recommending your service !!!

R.D. 19 June 2016

Experience, relevant data sourcing that is not often though about, consistency using both technical and fundamental inputs, as well as the understanding of market psychology, contrarian behaviour and sentiment.

J.E. 29 May 2016

I'm a long time subscriber and very familiar with the service!

T.M. 15 April 2016

Essential chart library plus interesting thematic comment

N.B. 06 April 2016

Good product, simple as that.

D.S. 05 April 2016

I appreciate David and Eoin's insightful, level-headed commentary.

M.N. 30 March 2016

It's a very time efficient and considered source of financial information.

H.T. 16 March 2016

I have subscribed for many years. I value David's judgement highly - he has made some excellent investment calls and his commentary is often insightful. The Chart library is a particularly useful resource.

A.L. 11 March 2016

Global scope, technical analysis, Fullers verbal.

J.P. 04 February 2016

Very long time subscriber and found service helpful in not missing major trends

S.O. 20 January 2016

I have been a long term satisfied customer myself.

C.B. 11 January 2016

Informative and consistent, good overview

R.M. 06 December 2015

Excellent daily coverage of the markets. The chart library is central to my investing. The Filter function is a gem.

D.B. 02 December 2015

Happily followed for many years

J.D. 24 November 2015

Long term subscriber, very satisified with quality of service

E.M. 21 October 2015

I am an extremely satisfied subscriber. The daily audio is an indispensable part of my day, and the chart library is a very powerful and convenient tool.